Monetary Business Cycle Models: Imperfect Information∗

Business cycle theories based on incomplete information start from the premise that key economic decisions on pricing, investment or production are often made on the basis of incomplete knowledge of constantly changing aggregate economic conditions. As a result, decisions tend to respond slowly to changes in economic fundamentals, and small or temporary economic shocks may have large and long-lasting effects on macroeconomic aggregates. Incomplete information theories have been popular in particular for explaining sluggish price or wage adjustment in response to monetary shocks. At the heart of this theory lies the assumption that firms or households only pay attention to a relatively small number of indicators regarding conditions in markets relevant to their own activities, but they may not acquire information more broadly about aggregate economic activity. With imprecise information about these aggregate conditions, it takes the firms some time to sort out temporary from permanent changes, or nominal from real disturbances. Prices then respond with a delay to changes in nominal spending, and monetary shocks may have significant effects on real economic activity in the intervening periods despite the fact that firms have the opportunity to constantly readjust their decisions. This basic idea was proposed first by Phelps (1970) and formalized by Lucas (1972). In Lucas (1972), economic agents produce in localized markets, in which they observe the market-clearing price at which they can sell their output. This price is affected both by aggregate spending shocks and by market-specific supply shocks. Under perfect information, quantities adjust in response ∗S. N. Durlauf and L. E. Blume, The New Palgrave Dictionary of Economics, forthcoming, Palgrave Macmillan, reproduced with permission of Palgrave Macmillan. This article is taken from the authors’ original manuscript and has not been reviewed or edited. The definitive published version of this extract may be found in the complete New Palgrave Dictionary of Economics in print and online, forthcoming. †Email: [email protected]