Monetary Policy Activism and Price Responsiveness to Aggregate Shocks under Rational Inattention

Abstract

This paper presents a general equilibrium model that is consistent with recent empirical evidence showing that the U.S. price level and in ‡ation are much more responsive to aggregate technology shocks than to monetary policy shocks. The model of this paper builds on recent work by Mackowiak and Wiederholt (2009), who show that models of endogenous attention allocation deliver prices to be more responsive to more volatile shocks as, everything else being equal, …rms pay relatively more attention to more volatile shocks. In fact, according to the U.S. data, aggregate technology shocks are more volatile than monetary policy shocks inducing in this paper, …rms to pay more attention to the former than to the latter. However, most important, this work adds to the literature by showing that the ability of the model of this paper to account for observed price dynamics crucially depends on monetary policy. In particular, this paper shows how interest rate feedback rules affect the incentives faced by …rms in allocating attention. A policy rate responding more actively to expected in ‡ation and output ‡uctuations induces …rms to pay relatively more attention to more volatile shocks. This new mechanism of transmission of monetary policy helps rationalizing the observed behavior of prices in response to technology and monetary policy shocks, and implies novel predictions about the impact of changes in Taylor rules coe¢ cients on economic ‡uctuations.

Does Inflation Adjust Faster to Aggregate Technology Shocks than to Monetary Policy Shocks?

“…Inflation adjustment speed has substantially increased to technology shocks in the Volcker–Greenspan period relative to the pre‐Volcker period, while it has changed less over time after a monetary policy shock. These results are consistent, for instance, with predictions of models of price setting under imperfect information as in Mackowiak and Wiederholt (2010) and Paciello (Forthcoming). According to these models, a policy that stabilizes more the price level induces firms to pay more attention to productivity shocks relatively to nominal shocks, inducing a faster response of inflation to the former than to the latter 2 .…”

“…These results are interesting, for instance, from the perspective of models of price setting under rational inattention. Paciello (Forthcoming) shows, in fact, that the allocation of attention by firms and, hence, the speed of inflation adjustment crucially depend on the systematic response of monetary policy to expected inflation and output fluctuations.…”

Business Cycle Dynamics under Rational Inattention

“…Decision-makers in rms who are responsible for setting prices therefore pay close attention to market-speci c conditions, quite a bit of attention to aggregate technology, and little attention to monetary policy. 27 For comparison, we solved the Calvo model with the same preference, technology, and monetary policy parameters. The motivation for this comparison is that the Calvo model is the most commonly used model for monetary policy analysis.…”

Exogenous Information, Endogenous Information, and Optimal Monetary Policy

“…For values of (μ/ω) between 1 * 10 −4 and 4 * 10 −4 , the per-period welfare gain from implementing the optimal monetary policy is quite large: about one third of a percent of steady state consumption. 22 Hence, for these values of (μ/ω), the central bank has a substantial incentive to become informed about aggregate conditions to implement the optimal monetary policy. At the same time, this optimal monetary policy makes the variance of the profit-maximizing price due to aggregate shocks sufficiently small such that price setters in firms pay no attention to aggregate conditions.…”

“…The figure looks similar for ρ a = 0.95 and σ ε = 0.0085, which again implies σ 2 a = (0.0085) 2 / 1 − (0.95) 2 . 22 Maćkowiak and Wiederholt (2010) solve a DSGE model with rational inattention and a Taylor rule. They find that for a value of (μ/ω) between 1 * 10 −4 and 2 * 10 −4 the model matches various empirical impulse responses of prices to shocks.…”