Expectations and fluctuations : the role of monetary policy

Abstract

This paper reconsiders the effects of expectations on economic uctuations. It does so within a competitive monetary economy which features producers and consumers with heterogeneous information about productivity. Agents' expectations are coordinated by a noisy public signal which generates non-fundamental, purely expectational shocks. I show that, depending on how monetary policy is pursued, purely expectational shocks can resemble either demand shocks, as conventionally thought, or supply shocks?increasing output and employment yet lowering ination. On the policy front, conventional policy recommendations are overturned: ination stabilization is suboptimal, whereas output-gap stabilization is optimal.