Optimal Monetary Policy with Imperfect Common Knowledge

This Paper studies optimal nominal demand policy in a flexible price economy with monopolistic competition and inattentive firms (Shannon). Inattentiveness gives rise to idiosyncratic information errors and imperfect common knowledge about the shocks hitting the economy. Strategic complementarities in the price-setting game between firms then strongly amplify the effects of information frictions and the real effects of monetary policy. Therefore, strategic complementarities make it optimal to stabilize the output gap by nominally accommodating shocks to firms’ desired mark-up. As mark-up shocks become more persistent, however, optimal policy is again increasingly characterized by price level stabilization. Shocks to the natural rate of output are found not to generate a policy trade-off.