Rationally Confused: Persistent Responses to Transitory Shocks

Hassan Afrouzi

No 1467, 2019 Meeting Papers from Society for Economic Dynamics

Abstract: In an analytical framework, we study how an economy with rationally inatten- tive firms responds to supply and demand shocks. Firms optimally choose to ignore the nature of shocks in favor of having a better estimate of how those shocks affect their prices. As a result, in our economy, when firms get signals that they should increase their price, they are confused about whether the underlying shock is a positive demand shock or a negative supply shock. This has significant implications for monetary policy: we prove that if monetary policy shocks are not persistent enough, every expansion caused by a positive policy shock will lead to a recession as firms would interpret it as a negative supply shock. This favors policies such as interest rate smoothing.

Date: 2019
New Economics Papers: this item is included in nep-dge
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed019:1467

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