Sunspots and the Nature of Price Rigidity

It is well known that increasing returns to scale and firms’ market power are two potential sources of sunspot expectations in Neoclassical models. In this paper we show that both the degree of returns to scale and market power can have fundamentally different implications for self-fulfilling expectations in New Keynesian models depending on the nature of price rigidity. As a result, the design of stabilization monetary policy can depend in a delicate way on precise knowledge about these real and nominal features of the economy. Thus, a clear understanding of the specific economic environment and its relevance to monetary policymaking for ensuring macroeconomic stability should be an integrated part of monetary policy practice. JEL classification: E12; E31; E52