Abstract
An autonomous demand shock affects consumption spending. Variations in
consumption spending contribute to the volatility in aggregate demand. As
the investor is risk averse, volatility of aggregate demand reduces
investment. Government injects monetary noise to reduce the volatility in
aggregate demand and induce higher investment. Monetary noise clouds the
observation of autonomous aggregate demand by the consumer who forms
Bayesian beliefs that are consistent with the equilibrium they supported for
forecasting autonomous aggregate demand and monetary noise. With a
greater monetary noise, the consumer relies less on the inaccurate
observation of autonomous aggregate demand and more on the prior
distribution functions of autonomous aggregate demand and monetary noise
to decide upon the level of consumption spending. Consumption spending
therefore reflects less of the volatility in autonomous aggregate demand.
Faced with a less volatile consumption spending, the investor increases
investment.
