Monetary Policy under Imperfect Common Knowledge: Theory and Experimental Evidence

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This project aims at extending dynamic stochastic general equilibrium (DSGE) models for analyzing the impact of macroeconomic shocks and monetary policy towards imperfect common knowledge. Rigidities in prices, wages or information can explain non-neutrality of monetary policy and sluggish adjustments of the economy to shocks. Currently, sticky information delivers the best fit of impulse response functions with observed data. However, this approach is criticized for its assumption that in each period only a fraction of firms has access to new information, while in reality relevant information is publicly available.Experimental evidence shows that public information does not lead to common knowledge. Instead, observed behaviour can be better explained by assuming that agents employ limited degrees of rationality (higher order beliefs) in their expectations about the beliefs of other agents.In this project, we will apply models of strategic uncertainty that incorporate limited levels of higher order beliefs to models of monetary policy, in particular DSGE models. We want to answer whether they yield an acceptable fit of impulse response functions with observed data (potentially better than the sticky price model), whether our alternative modelling approach implies different strategies for optimal monetary policy, what these strategies are, and how the degree of higher order beliefs can be affected by central bank transparency.