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

48 Pages Posted: 22 Jul 2009 Last revised: 7 Oct 2009

See all articles by Luigi Paciello

Luigi Paciello

Einaudi Institute for Economics and Finance (EIEF)

Date Written: July 22, 2009

Abstract

This paper presents a general equilibrium model that is consistent with recent empirical evidence showing that the U.S. price level and inflation 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, firms 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, firms 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 firms in allocating attention. A policy rate responding more actively to expected inflation and output fluctuations induces firms 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 coefficients on economic fluctuations.

Keywords: Rational inattention, price responsiveness, monetary policy

JEL Classification: E3

Suggested Citation

Paciello, Luigi, Monetary Policy Activism and Price Responsiveness to Aggregate Shocks under Rational Inattention (July 22, 2009). Available at SSRN: https://ssrn.com/abstract=1437506 or http://dx.doi.org/10.2139/ssrn.1437506

Luigi Paciello (Contact Author)

Einaudi Institute for Economics and Finance (EIEF) ( email )

Via Due Macelli, 73
Rome, 00187
Italy

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