The objectives of this paper are: (1) to study the effect of monetary policy on the expectation driven business cycles (Pigou cycles); (2) to find the Ramsey optimal monetary policy for the economy in our model hit by a news shock and compare this Ramsey optimal policy with several simple monetary policy rules. We are particularly interested in studying if central bank can mimic the Ramsey optimal policy by targeting only several macroeconomic variables.
Beaudry and Portier (2004) formalized Pigou (1926)’s idea and defined Pigou cycles as: (i) agents receive signals or news indicating that technology will improve in near future. An optimistic forecast of future technological improvement leads to a boom defined as an increase in aggregate output, employment, investment and consumption, and (ii) the realization that a forecast is too optimistic leads to a recession defined as a fall in all the same aggregate variables. The economy is said to be hit by a news shock. They also illustrate that standard one-sector and two-sector equilibrium models used in the macroeconomic literature can not produce Pigou cycles. Of course, their largest contribution is to find a particular multi-sector model in which Pigou cycles can arise. Their finding is that expectation driven business cycle can arise in neo-classical models when one allows for a sufficiently rich description of inter-sector production technology. In particular, the key assumption giving rise to the Pigou cycle is that non-durable goods and durable goods exhibit enough complementarities in the production of the final goods.
Beaudry and Portier’s work arouses researchers’ interest in finding the possibility of generating expectation driven business cycles in one sector models. Christiano, Motto and Rostagno (2006) and Jaimovich and Rebelo (2006) succeed in generating booms and busts of consumptions, investments and outputs as defined in Pigou’s cycles by adding investment adjustment cost, variable utilization of capital, habit persistence in preference into a standard one sector model. However, it is not that straightforward to get a correct booms and busts of asset prices in their frameworks. The asset prices unexpectedly slump during the booms when all the other variables rise as expected. To solve this problem, Christiano, Motto and Rostagno (2006) extend their model by adding sticky prices, sticky wages and standard Taylor-rule monetary policies. They argued that monetary policy plays an important role in generating a boom-bust cycle in asset prices.
In this paper, we formulate a dynamic general equilibrium model with two sectors that produce durable and non-durable goods respectively. The model incorporates nominal price rigidity in each sector. We study the expectation driven business cycles under Ramsey optimal policy and simple policy rules. The comparison of impulse responses indicates that Ramsey optimal policy can be approximated by a simple policy rule targeting inflation rates in both sectors with appropriate weights, and the weights are determined by the degree of nominal rigidities, depreciation rate of durable goods, and relative shares of durable goods output to non-durable goods output. We also conduct sensitivity analysis to show that this result is robust to various complementarities between non-durable goods and durable goods. Another interesting result is that central bank does not need to detect whether a boom is caused by a real technology improvement or just an expectation of improvement in technology. It is not necessary for central bank to detect whether an expectation will realize or not either. A simple policy rule targeting inflation in both sectors with appropriate weights can mimic the Ramsey policy rule closely under all circumstances.
This structure also allows us to study the following problem: is complementarities between non-durable goods and durable goods still a necessary condition to generate expectation driven business cycles when monetary policy exists in the model? Our finding indicates that monetary policy plays an important role in generating Pigou’s cycles. In particular, a weak inflation targeting policy rule helps generate Pigou’s cycles without assuming complementarities between non-durable goods and durable goods.
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Optimal Monetary Policy and Expectation Driven Business Cycles
