This paper examines a model of dynamic price adjustment based on the assumption that information disseminates slowly throughout the population. Compared with the commonly used sticky-price model, this sticky-information model displays three related properties that are more consistent with accepted views about the effects of monetary policy. First, disinflations are always contractionary (although announced disinflations are less contractionary than surprise ones). Second, monetary policy shocks have their maximum impact on inflation with a substantial delay. Third, the change in inflation is positively correlated with the level of economic activity.

This paper is a contribution to the analysis of optimal monetary policy. It begins with a critical assessment of the existing literature, arguing that most work is based on implausible models of inflation-output dynamics. It then suggests that this problem may be solved with some recent behavioral models, which assume that price setters are slow to incorporate macroeconomic information into the prices they set. A specific such model is developed and used to derive optimal policy. In response to shocks to productivity and aggregate demand, optimal policy is price level targeting. Base drift in the price level, which is implicit in the inflation targeting regimes currently used in many central banks, is not desirable in this model. When shocks to desired markups are added, optimal policy is flexible targeting of the price level. That is, the central bank should allow the price level to deviate from its target for a while in response to these supply shocks, but it should eventually return the price level to its target path. Optimal policy can also be described as an elastic price standard: the central bank allows the price level to deviate from its target when output is expected to deviate from its natural rate.

Information regarding economic fundamentals is widely dispersed in society, is only imperfectly aggregated through prices or other indicators of aggregate activity, and can not be centralized by the government or any other institution. In this paper we seek to identify policies that can improve the decentralized use of such dispersed information without requiring the government to observe this information. We show that this can be achieved by appropriately designing the contingency of taxation on ex-post public information regarding the realized fundamentals and aggregate activity. When information is common (as in the Ramsey literature) or when agents have private information only about idiosyncratic shocks (as in the Mirrlees literature), the contingency on fundamentals alone suffices for efficiency. When instead agents have private information about aggregate shocks, the contingency on aggregate activity is crucial. An appropriate combination of the two contingencies permits the government to: (i) dampen the impact of noise and hence reduce non-fundamental volatility, without also dampening the impact of fundamentals; (ii) induce agents to internalize informational externalities, and hence improve the speed of social learning; (iii) restore a certain form of constrained efficiency in the

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Istudytheeffects of a lack of common knowledge on nominal adjustment in a dynamic price-setting game with incomplete information. In particular, I show how the speed of price adjustments following a nominal or real shock depends on the information structure among pricesetters. The provision of public information leads to a reduction of higher-order uncertainty, and hence to more rapid price adjustments, but it potentially comes at the cost of an increased exposure to informational noise. I extend my analysis to allow for other disturbances, showing that higher-order uncertainty may account for the persistence of any kind of shock. Finally, I reconsider the role of monetary policy and discuss how the central bank’s policy actions may act as a focal point for market beliefs and hence affect nominal and real adjustment through its "coordination effect".

Strategic thinking, best-response, and mutual consistency (equilibrium) are three key modeling principles in noncooperative game theory. This paper relaxes mutual consistency to predict how players are likely to behave in one-shot games before they can learn to equilibrate. We introduce a one-parameter cognitive hierarchy (CH) model to predict behavior in one-shot games, and initial conditions in repeated games. The CH approach assumes that players use k steps of reasoning with frequency f(k). Zero-step players randomize. Players using k ( ≥ 1) steps best respond given partially rational expectations about what players doing 0 through k − 1 steps actually choose. A simple axiom which expresses the intuition that steps of thinking are increasingly constrained by working memory, implies that f(k) has a Poisson distribution (characterized by a mean number of thinking steps τ). The CH model converges to dominance-solvable equilibria when τ is large, predicts monotonic entry in binary entry games for τ < 1.25, and predicts effects of group size which are not predicted by Nash equilibrium. Best-fitting values of τ have an interquartile range of (.98,2.21) and a median of 1.55 across 60 experimental samples of matrix games, entry games and mixed-equilibrium games. The CH model also has economic value because subjects would have raised their earnings substantially if they had best-responded to model forecasts instead of making the choices they did. 1

Using data on cross-sectional dispersion in forecasters’long- and short-run predictions of macroeconomic variables, we identify key sources of disagreement. Dispersion among forecasters is highest at long horizons where private information is of limited value and lower at short forecast horizons. Moreover, differences in views persist through time. Such differences in opinion cannot be explained by differences in information sets; our results indicate they stem from heterogeneity in priors or models. We also find evidence that differences in opinion move countercyclically, with heterogeneity being strongest during recessions where forecasters appear to place greater weight on their prior beliefs. Keywords: Dispersion in beliefs, heterogeneous information, term structure of forecasts.

This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. This paper motivates and describes an approach to forecasting and monetary policy analysis based on the use of a simple structural macroeconomic model, along the lines of those in use in a number of central banks. It contrasts this approach with financial programming and its emphasis on monetary aggregates, as well as with more econometrically driven analyses. It presents illustrative results from an application to Canada. A companion paper provides a more detailed how-to guide and introduces a set of tools designed to facilitate this approach.

Inflation targeting has been widely adopted in both developed and emerging economies. In this essay, I survey the evidence on the effects of inflation targeting on macroeconomic performance and assess what lessons this evidence provides for inflation targeting and the design of monetary policy. While macroeconomic experiences among both inflation targeting and non-targeting developed economies have been similar, inflation targeting has improved macroeconomic performance among developing economies. Importantly, inflation targeting has not been associated with greater real economic instability among either developed or developing economics. While cost shocks, such as the large rise in commodity prices that occurred in 2007 and early 2008, force central banks to make difficult short-run trade-offs, the ability to deal with demand shocks and financial crises can be enhanced by a commitment to an explicit target. This article was adapted from the John Kuszczak Memorial Lecture, prepared for the conference on ‘International Experience with the Conduct of Monetary Policy under Inflation Targeting’, held at the Bank of Canada, 22–23 July 2008. I would like to thank Mahir Binici for excellent research assistance and conference participants and an anonymous referee for comments and suggestions. Views expressed and remaining errors are my own.

This paper investigates an RBC economy that features dispersed information about the underlying aggregate productivity shocks and, potentially, shocks to tastes or monopoly power. We show how the heterogeneity of information can (i) contribute to significant inertia in the response of macroeconomic outcomes to such shocks; (ii) induce a negative short-run response of employment to productivity shocks; (iii) imply that productivity shocks explain only a small fraction of short-run fluctuations; (iv) imply that the bulk of such fluctuations are driven by noise; (v) formalize a certain type of demand shocks within an RBC economy; and (vi) generate cyclical variation in observed labor wedges and Solow residuals. Importantly, none of these properties requires significant uncertainty about the underlying fundamentals: they rest on the heterogeneity of information and the strength of general-equilibrium linkages. Finally, none of these properties are symptoms of inefficiency: apart from undoing monopoly distortions, no stabilization policy can improve upon the equilibrium allocations.