Sticky Information: A Model of Monetary Nonneutrality and Structural Slumps [report]

N. Gregory Mankiw, Ricardo Reis
2001 unpublished
This paper is prepared for a conference in honor of Ned Phelps, October 2001. We thank Laurence Ball and Andrew Caplin for comments. Reis is grateful to the Fundacao Ciencia e Tecnologia, Praxis XXI, for financial support, and to Jonathan Leape and the CEP at the LSE for their hospitality during part of this research. Abstract This paper explores a model of wage adjustment based on the assumption that information disseminates slowly throughout the population of wage setters. This informational
more » ... This informational frictional yields interesting and plausible dynamics for employment and inflation in response to exogenous movements in monetary policy and productivity. In this model, disinflations and productivity slowdowns have a parallel effect: They both cause the path of employment to fall below the level that would prevail under full information. The model implies that, in the face of productivity change, a policy of targeting either nominal income or the nominal wage leads to more stable employment than does a policy of targeting the price of goods and services. Finally, we examine U.S. time series and find that, as the model predicts, unemployment fluctuations are associated with both inflation and productivity surprises. How do employment and inflation respond to real and monetary forces? What frictions cause these macroeconomic variables to deviate from the ideals that would arise in a fully classical world? These questions are at the center of macroeconomic research, as well as at the center of much of Ned Phelps's formidable research career. Early in his career Phelps (1967 Phelps ( , 1968 , together with Milton Friedman (1968), gave us the natural rate hypothesis, which remains the benchmark for understanding monetary nonneutrality. More recently, Phelps's work on structural slumps (1994) has examined the real forces that can cause the natural rate of unemployment to change over time. This paper offers a model that weaves together these two threads of Phelps's work. In this model, information is assumed to disseminate slowly throughout the population of wage setters, and as a result, wages respond slowly to news about changing economic conditions. Our model includes two kinds of relevant information: news about aggregate demand, as determined by monetary policy, and news about equilibrium real wages, as determined by productivity. We introduce this sticky-information model in Section I. The model generalizes the one in Mankiw and Reis (2001) . In the earlier paper, we applied the assumption of sticky information to the price-setting process in order to understand the dynamic response of the economy to monetary policy. The resulting model has three properties that are consistent with the conventional wisdom of central bankers and the empirical evidence of macroeconometricians. First, disinflations in the model are always contractionary (although announced disinflations are less contractionary than surprise ones). Second, the model predicts that monetary policy shocks have their maximum impact on inflation with a substantial delay. Third, given a realistic stochastic process for money growth,
doi:10.3386/w8614 fatcat:artgvrhmhjcz5iq3yeygvhusge