Optimal monetary policy with imperfect common knowledge

This paper determines optimal nominal demand policy in a flexible price economy in which firms pay limited attention to aggregate variables. Firms' inattentiveness gives rise to idiosyncratic information errors and imperfect common knowledge about the shocks hitting the economy. This is shown to have strong implications for optimal nominal demand policy. In particular, if firms' prices are strategic complements and economic shocks display little persistence, monetary policy has strong real effects, making it optimal to stabilize the output gap. Weak complementarities or sufficient shock persistence, however, cause price level stabilization to become increasingly optimal. With persistent shocks' optimal monetary policy shifts from output gap stabilization in initial periods following the shock to price level stabilization in later periods, potentially rationalizing the medium-term approach to price stability adopted by some central banks. (c) 2006 Elsevier B.V. All rights reserved.