Discussion Paper Series 2006-E-5

Imperfect Common Knowledge, Staggered Price Setting, and the Effects of Monetary Policy

Ichiro Fukunaga

This paper studies the consequences of a lack of common knowledge in the transmission of monetary policy by integrating the Woodford (2003a) imperfect common knowledge model with Taylor-Calvo staggered price-setting models. The average price set by monopolistically competitive firms who can only observe the state of the economy through noisy private signals depends on their higher-order expectations about not only the current state but also about the states in the future periods in which prices are to be fixed. This integrated model provides a plausible explanation for the observed effects of monetary policy: it shows analytically how price adjustments are delayed and how the response of output to monetary disturbances is amplified. I also consider a more general information structure in which a noisy public signal, in addition to the private signals, is introduced.

Keywords: Imperfect common knowledge; Higher-order expectations; Public and private information; Staggered price setting

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

Copyright © 2006 Bank of Japan All Rights Reserved.

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