Time-changing contention and cash transfer – Bank Underground

Fania Aissady

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In macroeconomic models, it is often assumed that economic agents are strictly observing the current situation, but in reality they have to infer current (instantaneous) conditions. Because of information costs, this is not always easy. Information costs are not observable in the data but can be represented. A good proxy is disagreement over the near-term forecast because high disagreement indicates that current economic conditions are more difficult to monitor – i.e. higher information frictions. If nowcasting varies over time, this could affect the ability of agents to respond to various shocks, including monetary policy shocks. My recent paper shows that when disagreement is higher, contractionary monetary policy lowers inflation, at the cost of an even greater decline in economic activity.

What does the discord look like in the data?

The dispute varies over time. This is a simple fact captured in many different surveys, from households, companies, and professional forecasters, as well as a variety of variables and a range of different forecasting horizons, from nowcasts to 10 years ahead. The intuition behind this flowery fact is that people are not fully informed all the time This naturally creates heterogeneity in beliefs. People use the information they have to make decisions and they make decisions not just once, but repeatedly over time. In making decisions, at each period, people choose whether it is beneficial to reorient their attention and how much – to make the degree of difference change over time.

As a starting point, it’s helpful to first get a sense of what discord looks like in the data. In my research, the discord is captured by the quartile range of real GDP now streamed from the US Survey of Professional Forecasters (SPF). The SPF is one of the longest-running macroeconomic surveys, covering a wide variety of events in the macroeconomic history of the United States, including the important economic events of the 1970s. Professional forecasters are among the most informed groups in economics, so the SPF serves as a conservative criterion for measuring information costs (information friction). If there is an increase in information friction, which reduces the ability of a professional forecaster to predict macroeconomic groups—despite all the publicly available information and forecasting techniques—then one can expect higher information frictions between firms and households.

How do varying degrees of information friction affect the transmission mechanism of monetary policy?

To answer this question, I estimate country-dependent domestic projections on US data over the period 1970-2013. Local projections have been used to study time-varying effects, as they can be easily adapted to estimate state-dependent models. This method allows the response of output and inflation to a monetary policy shock to vary depending on how much disagreement there is. Monetary policy shocks are identified through a narrative approach along the lines of La Romer and Romer (2004) and shocks in both high and low disagreement periods are estimated.

The results show that when disagreement is higher, prices respond more slowly to monetary shocks. Firmer prices give a flatter Phillips curve, which leads to the empirical finding that monetary policy has stronger effects on economic activity. During periods of significant disagreement, output responds fairly quickly to narrative monetary policy shocks. Conversely, the output response is silent for a longer period when the discordance is lower. This result arises from higher rates of price stickiness in periods of high contention. At the bottom of it, during the growing dispute, prices fall by 0.8% and output by 1%. These results are robust to the use of forecast (as opposed to nowcast) and inflation (rather than output) disagreement.

Interpretation of experimental results based on rational inattention

To understand why disagreement is crucial to monetary policy, I build a logical, traceable oblivious model in which nowcasting is costly and firms decide how to optimally allocate their attention.

There is a rapidly growing literature using models of rational inattention to understand monetary policy transmission. However, these models have not been used much to explain empirical evidence for state-dependent monetary transfer. In my research, the rational inattention model provides an explanation for empirical findings by showing how price determination changes with varying information frictions, as well as how they affect output and inflation. In periods when informational frictions are intense, price-fixing firms pay less attention to demand conditions. This means that their prices will respond slowly to monetary policy shocks. The slower the price response, the more “sticky” prices appear. More stable prices lead to smaller price adjustments. Combined with higher nominal rigidity, this inertia is price adjustments that result in a flatter Phillips curve, which results in larger effects of monetary policy on output.

Anatomy of Discord and Uncertainty

While there is a large literature on uncertainty, the dispute has received comparatively less attention while perhaps being more important in examining the macroeconomic effects of information friction. The new insight from this model is the ability to distinguish between uncertainty and disagreement. Explain how the two features have different effects on the cash transfer mechanism. Uncertainty about demand moves with divergence when interest in aggregate demand is already relatively high, so that paying extra attention yields a lower marginal benefit. Hence, companies do not reallocate more attention to demand, which leads to increased contention. On the other hand, when the concern assigned to demand is still relatively low, an increase in the uncertainty in demand increases the utility of demand control. Firms can then optimally reallocate more attention to demand control, which reduces demand stickiness.

Policy implications

My paper illustrates the important role of central bank communication. During periods of low contention, contractionary monetary policy is able to reduce inflation significantly with a relatively small cost of production. This raises the potentially important role of communicating aggregate conditions to economic agents, enabling firms and households to accommodate contractionary monetary policy, effectively making prices more elastic. This leads to a lower sacrifice ratio and enables the inflation-targeting central bank to better achieve its targets.

Fania Aissady He works at the bank Division of current economic conditions.

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Comments will appear once approved by the moderator, and will only be posted when full name is submitted. Bank Underground is a blog for Bank of England staff to share opinions that challenge – or support – mainstream, conventional politics. The opinions expressed herein are those of the authors, and are not necessarily those of the Bank of England or its policy committees.

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