NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Imperfect Common Knowledge and the Effects of Monetary Policy

Michael Woodford

NBER Working Paper No. 8673
Issued in December 2001
NBER Program(s):   EFG   ME

This paper reconsiders the Phelps-Lucas hypothesis, according to which temporary real effects of purely nominal disturbances result from imperfect information, but departs from the assumptions of Lucas (1973) in two crucial respects. Due to monopolistically competitive pricing, higher-order expectations are crucial for aggregate inflation dynamics, as argued by Phelps (1983). And decisionmakers' subjective perceptions of current conditions are assumed to be of imperfect precision, owing to finite information processing capacity, as argued by Sims (2001). The model can explain highly persistent real effects of a monetary disturbance, and a delayed effect on inflation, as found in VAR studies.

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Document Object Identifier (DOI): 10.3386/w8673

Published: Aghion, P., R. Frydman, J. Stiglitz, and M. Woodford (eds.) Knowledge, Information and Expectations in Modern Macroeconomics. Princeton: Princeton University Press, 2002.

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