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Can Ignorance Make Central Banks Behave?

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  • T. Christopher Canavan

    (Boston College)

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    Abstract

    This paper presents a model in which "instrument uncertainty"-that is, an uncertain mapping from monetary policy to macroeconomic outcomes-may mitigate the inflationary bias problem that arises when efficient monetary policy rules are time- inconsistent. If the relation between monetary policy and macroeconomic outcomes is uncertain, the private sector has an incentive to scrutinize the past for clues about this relationship. This learning creates a link between past government behavior and present inflation expectations that the government can exploit to enhance its credibility. The model implies that the two conventional arguments for simple rules in monetary policy-one stressing the central bank's poor forecasting abilities and the other stressing the perils of discretion-may work at cross-purposes. Moreover, it provides an explanation of the cyclical behavior of inflation due to political cycles and of the correlation between the level and variance of inflation.

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    File URL: http://fmwww.bc.edu/EC-P/wp291.pdf
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    Bibliographic Info

    Paper provided by Boston College Department of Economics in its series Boston College Working Papers in Economics with number 291..

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    Length: 17 pages
    Date of creation: Jul 1995
    Date of revision:
    Handle: RePEc:boc:bocoec:291

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    Related research

    Keywords: instrument uncertainty; monetary policy; inflationary bias; time- inconsistency; learning.;

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    References

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    1. William Poole, 1970. "Optimal choice of monetary policy instruments in a simple stochastic macro model," Staff Studies 57, Board of Governors of the Federal Reserve System (U.S.).
    2. Logue, Dennis E & Willett, Thomas D, 1976. "A Note on the Relation between the Rate and Variability of Inflation," Economica, London School of Economics and Political Science, vol. 43(17), pages 151-58, May.
    3. Rogoff, Kenneth & Sibert, Anne, 1988. "Elections and Macroeconomic Policy Cycles," Review of Economic Studies, Wiley Blackwell, vol. 55(1), pages 1-16, January.
    4. Matthew B. Canzoneri & Dale W. Henderson & Kenneth S. Rogoff, 1981. "The information content of the interest rate and optimal monetary policy," International Finance Discussion Papers 192, Board of Governors of the Federal Reserve System (U.S.).
    5. Vickers, John, 1986. "Signalling in a Model of Monetary Policy with Incomplete Information," Oxford Economic Papers, Oxford University Press, vol. 38(3), pages 443-55, November.
    6. Kenneth Rogoff, 1987. "Reputational Constraints on Monetary Policy," NBER Working Papers 1986, National Bureau of Economic Research, Inc.
    7. Rogoff, Kenneth, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, MIT Press, vol. 100(4), pages 1169-89, November.
    8. Lohmann, Susanne, 1992. "Optimal Commitment in Monetary Policy: Credibility versus Flexibility," American Economic Review, American Economic Association, vol. 82(1), pages 273-86, March.
    9. Garfinkel, Michelle R & Oh, Seonghwan, 1993. "Strategic Discipline in Monetary Policy with Private Information: Optimal Targeting Horizons," American Economic Review, American Economic Association, vol. 83(1), pages 99-117, March.
    10. Canzoneri, Matthew B, 1985. "Monetary Policy Games and the Role of Private Information," American Economic Review, American Economic Association, vol. 75(5), pages 1056-70, December.
    11. Holbrook, Robert S, 1972. "Optimal Economic Policy and the Problem of Instrument Instability," American Economic Review, American Economic Association, vol. 62(1), pages 57-65, March.
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