Noisy Business Cycles (with George-Marios Angeletos) [download pdf]
In D. Acemoglu, K. Rogoff, and M. Woodford (eds.), NBER Macroeconomics Annual 2009, Volume 24, Forthcoming.
This paper investigates a real-business-cycle economy that features dispersed information about underlying aggregate productivity shocks, taste shocks, and—potentially—shocks to monopoly power. We show how the dispersion of information can (i) contribute to significant inertia in the response of macroeconomic outcomes to such shocks; (ii) induce a negative short-run response of employment to productivity shocks; (iii) imply that productivity shocks explain only a small fraction of high-frequency fluctuations; (iv) contribute to significant noise in the business cycle; (v) formalize a certain type of demand shocks within an RBC economy; and (vi) generate cyclical variation in observed Solow residuals and labor wedges. Importantly, none of these properties requires significant uncertainty about the underlying fundamentals: they rest on the heterogeneity of information and the strength of trade linkages in the economy, not the level of uncertainty. Finally, none of these properties are symptoms of inefficiency: apart from undoing monopoly distortions or providing the agents with more information, no policy intervention can improve upon the equilibrium allocations.
Incomplete Information, Higher-Order Beliefs and Price Inertia (with George-Marios Angeletos) [download pdf]
Journal of Monetary Economics, Volume 56:S, pp. 19-37 (October 2009).
The question that motivates this paper is how incomplete information affects the response of prices to nominal shocks. Our baseline model is a variant of the Calvo model in which firms observe the underlying nominal shocks with noise. In this model, the response of prices is pinned down by three parameters: the precision of available information about the nominal shock, the frequency of price adjustment, and the degree of strategic complementarity in pricing decisions. This result synthesizes the broader lessons of the pertinent literature. However, this synthesis provides only a partial view of the role of incomplete information. Once one allows for more general information structures than those used in previous work, one cannot quantify the degree of price inertia without data on the dynamics of higher-order beliefs, or of the agents' forecasts of inflation. We highlight this with three extensions of our baseline model, all of which break the tight connection between the precision of information and higher-order beliefs featured in previous work.