Monetary Policy and Price Informativeness under Rational Inattention

The project explores how monetary policy influences the signal value of prices for a central bank, in an environment where firms set prices under rational inattention. It analyses how changes in the environment (including the conduct of monetary policy) affect firms' allocation of attention and, in turn, how these affect price informativeness. It draws inspiration from two complementary strands of the literature and aims to reconcile insights from the two.

On one hand, several papers have noted that central banks face the problem of influencing market prices to achieve their objectives, while also observing prices to elicit information about the state of the economy. These papers emphasize the role of prices as aggregators of "dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess", as originally put forward by Hayek (1945). Consequently, they study how a policymaker should intervene and disclose information in imperfect common knowledge settings, where the central bank learns about economic fundamentals by observing prices. In the aforementioned models, firms take their information sets as given, so changes in monetary policy affect prices by changing the way in which firms respond to their (exogenous) private information about fundamentals.

This is in contrast to the rational inattention literature (following Sims (2003)), where firms' information sets are endogenous and react to changes in the environment, including the central bank's policy. Accounting for the endogenous nature of firms' information opens the door to new questions regarding price informativeness and its relation to monetary policy, uncovering novel mechanisms through which the central bank's ability to maximize social welfare is self-defeating. For instance, optimal monetary policy lowers the uncertainty faced by firms regarding their optimal prices, thereby causing firms to pay less attention to fundamental shocks. Thus, the firms' private information about fundamentals becomes relatively less precise and this renders prices as less informative to the policymaker (impeding the central bank's ability to learn about fundamentals by observing prices, and thus the policymaker's ability to neutralize shocks to fundamentals). In related work, I study how optimal monetary policy and price informativeness are affected by uncertainty regarding policy transmission (as in Brainard (1967), see short abstract below)).

Brainard Uncertainty and the Signal Value of Prices

One rationale standing behind caution in monetary policy-making is parameter uncertainty in the spirit of Brainard (1967). I account for such uncertainty in a model of monetary policy with price-setting under imperfect common knowledge (stemming from rational inattention) in which the policymaker learns about fundamentals by observing market prices, and study how the endogenous nature of the central bank's information affects optimal policy. Although policy intervention always influences the informational content of prices, this is only relevant for optimal policy if there is some degree of parameter uncertainty. Under Brainard uncertainty, there is both an incentive to experiment with policy (in order to elicit information about its transmission) and an incentive to be cautious with policy (in order to have more precise information about fundamentals).