Public and Private Information in Monetary Policy Models

We examine the impact of public information in an economy where agents also have diverse private information. Our work builds on seminal contributions by Townsend (1983) and Phelps (1983), and more recently Woodford (2002), which emphasized the importance of higher-order beliefs – that is, beliefs about the beliefs of others – in an environment where agents’ interests are intertwined. Following Woodford, our focus is on the pricing behaviour of monopolistically competitive firms, where the intertwining of interests arises from strategic complementarity in the pricing decisions of firms. In setting prices, firms try to second-guess prices set by their competitors. Our analysis proceeds in two steps. Beginning with a series of simplified examples, we show how differentially informed firms follow pricing rules that suppress their own information, but instead put disproportionately large weight on commonly shared information. For reasonable degrees of strategic complementarity, the aggregate price suffers substantial information loss, and therefore ceases to be an informative signal of the underlying demand and cost conditions. We follow this up by developing a general equilibrium model incorporating households and the central bank. We find that the disproportionate role of public information degrades the informational value of economic outcomes for firms and the policymaker alike, alters the welfare consequences of increased precision of public information and generates distinctive time series characteristics of some macro variables. In part, these results extend a recent finding by Morris and Shin (2002) that increased precision of public information may impair social welfare in a game of second-guessing reminiscent of Keynes's `beauty contest'. Finally, we trace out the welfare implications of different parametrizations of the policy rule, particularly focusing upon the implications of the relative precision of private and public informationhigher-order beliefs, strategic complementarity, Kalman filter