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Abstract This paper studies optimal fiscal and monetary policy under sticky product prices. The theoretical framework is a stochastic production economy without capital. The government finances an exogenous stream of purchases by levying distortionary income taxes, printing money, and issuing one-period nominally risk-free bonds. The main findings of the paper are: First, for a miniscule degree of price stickiness (i.e., many times below available empirical estimates) the optimal volatility of inflation is near zero. This result stands in stark contrast with the high volatility of inflation implied by the Ramsey allocation when prices are flexible. The finding is in line with a recent body of work on optimal monetary policy under nominal rigidities that ignores the role of optimal fiscal policy. Second, even small deviations from full price flexibility induce near random walk behavior in government debt and tax rates, as in economies with real non-state-contingent debt only. Finally, sluggish price adjustment raises the average nominal interest rate above the one called for by the Friedman rule. JEL Classification: E52, E61, E63.

Economists have long emphasized the importance of expectations in determining macroeconomic outcomes. Yet there has been almost no recent effort to model actual empirical expectations data; instead, macroeconomists usually simply assume that expectations are "rational." This paper shows that while empirical household expectations are not rational in the usual sense, expectational dynamics are well captured by a model in which households' views derive from news reports of the views of professional forecasters, which in turn may be rational. The model's estimates imply that people only occasionally pay attention to news reports; this inattention generates "stickyness" in aggregate expectations, with important macroeconomic consequences.

This chapter examines the concept of inflation persistence in macroeconomic theory. It begins with a definition of persistence, emphasizing the difference between reduced-form and structural persistence. It then examines a number of empirical measures of reduced-form persistence, considering the possibility that persistence has changed over time. The chapter then examines the theoretical sources of persistence, distinguishing “intrinsic ” from “inherited” persistence, and deriving a number of analytical results on persistence. It summarizes the implications for persistence from the literatures on “stickyinformation” models, learning and so-called trend inflation models, providing some new results throughout.

The views expressed in this paper are those of the authors. No responsibility for them should be attributed to the Bank of Canada. This paper was prepared at Stanford University and was not edited by the Bank of Canada. iii

This paper investigates the role that imperfect knowledge about the structure of the economy plays in the formation of expectations, macroeconomic dynamics, and the efficient formulation of monetary policy. Economic agents rely on an adaptive learning technology to form expectations and to update continuously their beliefs regarding the dynamic structure of the economy based on incoming data. The process of perpetual learning introduces an additional layer of dynamic interaction between monetary policy and economic outcomes. We find that policies that would be efficient under rational expectations can perform poorly when knowledge is imperfect. In particular, policies that fail to maintain tight control over inflation are prone to episodes in which the public’s expectations of inflation become uncoupled from the policy objective and stagflation results, in a pattern similar to that experienced in the United States during the 1970s. Our results highlight the value of effective communication of a central bank’s inflation objective and of continued vigilance against inflation in anchoring inflation expectations and fostering macroeconomic stability.

Is the observed correlation between current and lagged inflation a function of backward-looking inflation expectations, or do the lags in inflation regressions merely proxy for rational forward-looking expectations, as in the new-Keynesian Phillips curve? Recent research has attempted to answer this question by using instrumental variables techniques to estimate “hybrid ” specifications for inflation that allow for effects of lagged and future inflation. We show that these tests of forward-looking behavior have very low power against alternative, but non-nested, backward-looking specifications, and demonstrate that results previously interpreted as evidence for the new-Keynesian model are also consistent with a backward-looking Phillips curve. We develop alternative, more powerful tests, which find a very limited role for forward-looking expectations.

Empirical evidence shows that observed macroeconomic fundamentals have little explanatory power for nominal exchange rates (the exchange rate determination puzzle). On the other hand, the recent "microstructure approach to exchange rates" has shown that most exchange rate volatility at short to medium horizons is related to order flow. In this paper we introduce symmetric information dispersion about future fundamentals in a dynamic rational expectations model in order to explain these stylized facts. Consistent with the evidence the model implies that (i) observed fundamentals account for little of exchange rate volatility in the short to medium run, (ii) over long horizons the exchange rate is closely related to observed fundamentals, (iii) exchange rate changes are a weak predictor of future fundamentals, and (iv) the exchange rate is closely related to order flow over both short and long horizons.

This paper presents a model of business cycles driven by shocks to consumer expectations regarding aggregate productivity. Agents are hit by heterogeneous productivity shocks, they observe their own productivity and a noisy public signal regarding aggregate productivity. The public signal gives rise to “noise shocks, ” which have the features of aggregate demand shocks: they increase output, employment and in‡ation in the short run and have no e¤ects in the long run. The dynamics of the economy following an aggregate productivity shock are also a¤ected by the presence of imperfect information: after a positive productivity shock output adjusts gradually to its higher long-run level, and there is a temporary negative e¤ect on in‡ation and employment. Numerical results suggest that the model can generate sizeable amounts of noise-driven volatility in the short run. JEL Codes: E32, D58, D83 Keywords: information. Consumer con…dence, aggregate demand shocks, business cycles, imperfect MIT and NBER. Email: glorenzo@mit.edu. A previous version of this paper circulated under the title:

Abstract—We study the price adjustment practices and provide quantitative measurement of the managerial and customer costs of price adjustment using data from a large U.S. industrial manufacturer and its customers. We � nd that price adjustment costs are a much more complex construct than the existing industrial-organization or macroeconomics literature recognizes. In addition to physical costs (menu costs), we identify and measure three types of managerial costs (information gathering, decision-making, and communication costs) and two types of customer costs (communication and negotiation costs). We � nd that the managerial costs are more than 6 times, and customer costs are more than 20 times, the menu costs. In total, the price adjustment costs comprise 1.22 % of the company’s revenue and 20.03 % of the company’s net margin. We show that many components of the managerial and customer costs are convex, whereas the menu costs are not. We also document the link between price adjustment costs and price rigidity. Finally, we provide evidence of managers ’ fear of antagonizing customers. I have no answer to the question of how to measure these menu change costs, but these [menu cost] theories will never be taken seriously until an answer is provided. Edward Prescott (1987, p. 113) Given the large number of theoretical papers that evaluate the implications of [price] adjustment costs, obtaining direct evidence that such costs are present seems crucial. Margaret Slade (1998, p. 104) I.