DP7643 Imperfect information and the business cycle

Author(s): Fabrice Collard, Harris Dellas, Frank Smets
Publication Date: January 2010
Keyword(s): Bayesian estimation, imperfect information, New Keynesian model, signal extraction
JEL(s): E32, E52
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=7643

Imperfect information has played a prominent role in modern business cycle theory. This paper assesses its importance by estimating the New Keynesian (NK) model under alternative informational assumptions. One version focuses on confusion between temporary and persistent disturbances. Another, on unobserved variation in the inflation target of the central bank. A third on persistent misperceptions of the state of the economy (measurement error). And a fourth assumes perfect information (the standard NK{DSGE version). Imperfect information is found to contain considerable explanatory power for business fluctuations. Signal extraction seems to provide a conceptually satisfactory, empirically plausible and quantitatively important business cycle mechanism.