Why Should Policy Makers Care About Inflation and Output Variability? The Role of Monetary Policy Stabilization under Asymmetric Information

In this paper we use an equilibrium model to derive the monetary policy maker's optimal response function, taking into account the interaction between individual firms and households and their participation in markets for goods and services. The theoretical formulation is used to set up a social optimization problem, where the main goal of society is to minimize inflation and output fluctuations around their steady-state values. The model presents a theoretical justification for the inflexibility of prices to move upward or downward, as a result of firms' inability to perfectly observe demand and supply shocks. This price stickiness arises solely as a consequence of uncertainty and imperfect competition, and, in the absence of policy intervention, this uncertainty can result in a more volatile economy. The proposed model not only allows us to show how monetary policy can have real effects in the short run as a result of the presence of asymmetric information in the economy, but it also serves a theoretical rationale for an activist role of central banks in macroeconomic stabilization.