Please use this identifier to cite or link to this item: http://hdl.handle.net/10419/72642
Authors: 
Adam, Klaus
Year of Publication: 
2003
Series/Report no.: 
CFS Working Paper 2003/12
Abstract: 
We study optimal nominal demand policy in an economy with monopolistic competition and flexible prices when firms have imperfect common knowledge about the shocks hitting the economy. Parametrizing firms' information imperfections by a (Shannon) capacity parameter that constrains the amount of information flowing to each firm, we study how policy that minimizes a quadratic objective in output and prices depends on this parameter. When price setting decisions of firms are strategic complements, for a large range of capacity values optimal policy nominally accommodates mark-up shocks in the short-run. This finding is robust to the policy maker observing shocks imperfectly or being uncertain about firms' capacity parameter. With persistent mark-up shocks accommodation may increase in the medium term, but decreases in the long-run thereby generating a hump-shaped price response and a slow reduction in output. Instead, when prices are strategic substitutes, policy tends to react restrictively to mark-up shocks. However, rational expectations equilibria may then not exist with small amounts of imperfect common knowledge.
Subjects: 
optimal policy
information frictions
imperfect common knowledge
higher order beliefs
Shannon capacity
JEL: 
E31
E52
D82
Persistent Identifier of the first edition: 
Document Type: 
Working Paper

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