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This paper studies monetary policy in an economy where output fluctuations are driven by the private sector's uncertainty about the economy's fundamentals.


Optimal Monetary Policy with Uncertain Fundamentals and Dispersed Information
Last Updated: 07/30/08

This paper studies monetary policy in an economy where output fluctuations are driven by the private sector's uncertainty about the economy's fundamentals. The author considers an economy where information on aggregate productivity is dispersed across agents and there are two aggregate shocks: a standard productivity shock and a 'noise shock' affecting public beliefs about aggregate productivity. Neither the central bank nor individual agents can distinguish the two shocks when they hit the economy. The main results are: first, despite the lack of superior information, an appropriate monetary policy rule can change the economy's response to the two aggregate shocks; second, monetary policy can achieve 'full aggregate stabilization,' that is, an equilibrium where aggregate activity is the same as in the case of full information; third, under optimal monetary policy, the economy achieves a constrained efficient allocation; and fourth, optimal monetary policy is typically different from full aggregate stabilization. Behind these results are two crucial ingredients. First, agents are forward looking. Second, as time passes, better information on past fundamentals becomes available. The central bank can then adopt a backward-looking policy rule, based on more precise information about past fundamentals. By announcing its response to future information, the central bank can influence the expected real interest rate faced by agents with different beliefs and thus induce an optimal use of the information dispersed in the economy.