Imperfect Common Knowledge, Staggered Price Setting, and the Effects of Monetary Policy

Authors


  • This paper is based upon the author's Ph.D. thesis at the London School of Economics and Political Science. The author gratefully acknowledge valuable suggestions and encouragement from his supervisor, Nobuhiro Kiyotaki. The author also thanks Wouter Den Haan, Neil Rankin, Andrei Sarychev, Hyun Song Shin, Takashi Ui, the staff at the Bank of Japan, and an anonymous referee for helpful comments. All remaining errors are the sole responsibility of the author. The views expressed in this paper are those of the author and do not necessarily reflect the official views of the Bank of Japan.

Abstract

This paper studies the consequences of a lack of common knowledge in the transmission of monetary policy by integrating the Woodford (2003a) imperfect common knowledge model with Taylor–Calvo staggered price-setting models. The average price set by monopolistically competitive firms depends on their higher-order expectations about not only the current state of the economy but also about the states in the future periods in which prices are to be fixed. This integrated model provides a plausible explanation for the observed effects of monetary policy: it shows analytically how price adjustments are delayed and how the response of output to monetary disturbances is amplified.

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