Monetary policy and sentiment-driven fluctuations

Jenny Chan

Journal of Economic Theory, 2024, vol. 222, issue C

Abstract: Sentiments, or beliefs about aggregate demand, can be self-fulfilling in models departing slightly from the complete information benchmark in the New Keynesian framework. Through its effect on aggregate variables, the policy stance determines the degree of complementarity in firms' production (pricing) decisions and consequently, the precision of endogenous signals that firms receive. As a result, aggregate fluctuations can be driven by both fundamental and non-fundamental shocks. The distribution of non-fundamental shocks is endogenous to policy, introducing a novel tradeoff between stabilizing output and inflation. Both strong inflation targeting and nominal flexibilities increase the variance of non-fundamental shocks, which are shown to be suboptimal. Moreover, the Taylor principle is no longer sufficient to rule out indeterminacy. Instead, an interest rate rule that places sufficiently low weight on inflation eliminates non-fundamental volatility and thereby the output-inflation tradeoff.

Keywords: New-Keynesian; Sunspots; Animal spirits; Rational expectations; Optimal monetary policy; Indeterminacy (search for similar items in EconPapers)
JEL-codes: E31 E32 E52 E63 (search for similar items in EconPapers)
Date: 2024
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jetheo:v:222:y:2024:i:c:s0022053124001340

DOI: 10.1016/j.jet.2024.105928

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