Information, Response Delays, and the Effects of Monetary Policy

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This project contributes to the understanding of the transmission mechanism of monetary policy, which is to say, of the way in which changes in monetary policy affect real activity and inflation. The primary aim of developing a more accurate model of these effects is to allow a more precise analysis of the consequences of adopting one or another monetary policy rule, and the calculation of an optimal rule. The analysis is grounded in optimizing private-sector behavior, in order to allow an analysis of the welfare consequences of alternative policies in terms of the extent to which private objectives are fulfilled.A defect of existing optimizing models of the monetary transmission mechanism is that they are too exclusively "forward-looking": both inflation and real activity are predicted to be determined purely by current and expected future interest-rate policy, with no effect of past conditions. Empirical evidence on the effects of monetary policy instead indicate the existence of response delays, that imply both that the effects of policy changes are not observed immediately and that they persist longer than do the effects upon interest rates. The project considers the consequences of two kinds of modifications of standard models that allow for response delays while still assuming optimizing behavior on the part of the private sector.The first class of models assumes that private decisionmakers do not continuously reoptimize in the light of current conditions, but instead only reconsider their actions after a certain interval. This allows a delay in the effects of a monetary policy change upon aggregate expenditure, on the ground that not everyone immediately revises their previous spending plans. When this model of intermittent optimization is applied to consumer expenditure, it has consequences for aggregate consumption similar to those of the recently popular hypothesis of "habit persistence", but without certain implications for individual household behavior that do not fit with panel data evidence.The second class of models assumes that private decisionmakers do not continually monitor current conditions with complete accuracy, in order to economize on limited information-processing capacity. It is assumed that decisionmakers monitor their environment using a "noisy channel" in the information-theoretic sense. This is not simply a metaphor, but provides a quantitative model of the sources of error in decisionmakers' perception of their environment, and in particular provides a useful way of quantifying the assumed constraint on information-processing capacity. This allows a delay in the effects of a monetary policy change, on the ground that decisionmakers are not immediately able to discern with certainty that the change has occurred. The resulting theory has some similarities to asymmetric-information models of the 1970s, but is able to answer important objections that were raised to those theories because the asymmetric information is based upon limitations upon individuals' ability to pay attention to everything in their environment, rather than upon any claim that the relevant data are not publicly available.An interesting feature of this type of model is that significant delays in price adjustment can result even when the information of individual price-setters about current aggregate conditions is relatively accurate. It suffices that (because the errors in observation resulting from inadequate channel capacity) there be significant uncertainty about what others may believe that others may believe that others may believe ... about the aggregate state. In other words, it is not uncertainty about the state of the economy so much as the absence of common knowledge that results in response delays. This approach to explaining response delays helps to explain aspects of the observed effects of monetary policy that optimizing models with sticky prices cannot, including differential speeds of response of prices to different types of shocks, and apparent stickiness of the rate of inflation (as opposed to the price level) under certain conditions.A more sophisticated version of this class of models seeks to explain the degree of precision with which individual variables are monitored by decisionmakers, by assuming a global channel-capacity constraint (a constraint upon the overall number of bits per period of information that can be pro-cessed), subject to which decisionmakers choose an optimal information-collection strategy. This offers the prospect of a theory that yields very tight predictions, and at the same time allows for important changes in information structure in response to changes in economic conditions, including sufficiently dramatic changes in monetary policy. The project considers the design of optimal monetary policies, both when the information structure is taken as given, and when endogenous response of the information structure to the policy regime is taken into account.