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Rational Ambiguity and Monitoring the Central Bank

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Author Info
Maria Demertzis
Andrew Hughes Hallet

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Abstract

In this paper we examine the consequences of having a Central Bank whose preferences are state contingent. This has been identified in the literature as a Central Bank that is `rationally inattentive' or `constructively ambiguous'. The new feature in this paper is that we show how the private sector is likely to react. There are two possibilities: the public can form rational expectations and internalise the uncertainty about the Central Bank's preferences in full. Alternatively, and if this process of internalisation is costly, it can form a `best' guess regarding those preferences and use that. This implies an equivalence strategy applied to the preference parameters. As those parameters enter the decisions nonlinearly, a systematc error emerges. We examine the magnitude of the resulting error in ination and output, following the assumption of certainty equivalence. Under all reasonable levels of uncertainty this error turns out to be small but it involves trading a deation bias against the cost of gathering the information needed for the full rational expectations solution.

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Paper provided by Netherlands Central Bank, Research Department in its series WO Research Memoranda (discontinued) with number 759.

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Length: 13 pages
Date of creation: May 2004
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Handle: RePEc:dnb:wormem:759

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Related research
Keywords: Central Bank Transparency; Certainty Equivalence; Rational Expectations; Ambiguity and Rational Inattention;

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  3. Walsh, Carl E, 1999. "Announcements, Inflation Targeting and Central Bank Incentives," Economica, London School of Economics and Political Science, vol. 66(262), pages 255-69, May. [Downloadable!] (restricted)
  4. Hansen, Lars Peter & Sargent, Thomas J & Tallarini, Thomas D, Jr, 1999. "Robust Permanent Income and Pricing," Review of Economic Studies, Blackwell Publishing, vol. 66(4), pages 873-907, October. [Downloadable!] (restricted)
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  5. Jon Faust & Lars E.O. Svensson, 1998. "Transparency and credibility: monetary policy with unobservable goals," International Finance Discussion Papers 605, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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  6. Lucas, Robert E, Jr, 1973. "Some International Evidence on Output-Inflation Tradeoffs," American Economic Review, American Economic Association, vol. 63(3), pages 326-34, June.
  7. Jordi Gali & Tommaso Monacelli, 2002. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," NBER Working Papers 8905, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  8. Cukierman, Alex & Meltzer, Allan H, 1986. "A Theory of Ambiguity, Credibility, and Inflation under Discretion and Asymmetric Information," Econometrica, Econometric Society, vol. 54(5), pages 1099-1128, September. [Downloadable!] (restricted)
  9. Jon Faust & Lars E.O. Svensson, 1999. "The equilibrium degree of transparency and control in monetary policy," International Finance Discussion Papers 651, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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  10. Sims, Christopher A., 2003. "Implications of rational inattention," Journal of Monetary Economics, Elsevier, vol. 50(3), pages 665-690, April. [Downloadable!] (restricted)
  11. Hughes Hallett, A. J., 1979. "Computing revealed preferences and limits to the validity of quadratic objective functions for policy optimization," Economics Letters, Elsevier, vol. 2(1), pages 27-32. [Downloadable!] (restricted)
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  14. Lucas, Robert Jr., 1972. "Expectations and the neutrality of money," Journal of Economic Theory, Elsevier, vol. 4(2), pages 103-124, April. [Downloadable!] (restricted)
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