Working Paper: CEPR ID: DP4594
Authors: Klaus Adam
Abstract: This Paper studies optimal nominal demand policy in a flexible price economy with monopolistic competition and inattentive firms (Shannon). Inattentiveness gives rise to idiosyncratic information errors and imperfect common knowledge about the shocks hitting the economy. Strategic complementarities in the price-setting game between firms then strongly amplify the effects of information frictions and the real effects of monetary policy. Therefore, strategic complementarities make it optimal to stabilize the output gap by nominally accommodating shocks to firms? desired mark-up. As mark-up shocks become more persistent, however, optimal policy is again increasingly characterized by price level stabilization. Shocks to the natural rate of output are found not to generate a policy trade-off.
Keywords: information imperfections; nominal demand management; private information; rational inattention; shannon capacity
JEL Codes: D82; E31; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| nominal demand policy (E19) | output gap stabilization (E63) |
| nominal demand policy (E19) | price level stabilization (E64) |
| persistence of markup shocks (C54) | effectiveness of monetary policy (E52) |
| nominal accommodation (Z30) | real output movements (E23) |