Monetary Misperceptions: Optimal monetary policy under incomplete information (SSRN)
Inflation targeting is strictly suboptimal when economic actors have incomplete information about the state of the economy. Nominal income targeting is approximately optimal, and exactly optimal under certain parameterizations. We derive this result in a “Lucas islands” monetary misperceptions model built from, unlike prior work, explicit microfoundations. Agents have knowledge of local productivity and money supply conditions, but must perform a signal extraction problem each period to estimate the aggregate productivity shock and the aggregate money supply shock. Without full information, agents cannot perfectly distinguish between relative price shocks and aggregate shocks, causing monetary policy to affect the real economy. Since the model is built from agents optimizing from first principles, we are able to take a second-order welfare approximation and ask what monetary policy rule is optimal. In contrast to sticky price or sticky information models, inflation and price level targeting are always suboptimal, as price level variation provides useful information to agents. Under log utility, nominal income targeting is optimal.