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Central bank transparency and nonlinear learning dynamics

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  • Stefano Eusepi

Abstract

Central bank communication plays an important role in shaping market participants' expectations. This paper studies a simple nonlinear model of monetary policy in which agents have incomplete information about the economic environment. It shows that agents' learning and the dynamics of the economy are heavily affected by central bank transparency about its policy rule. A central bank that does not communicate its rule can induce "learning equilibria" in which the economy alternates between periods of deflation coupled with low output and periods of high economic activity with excessive inflation. More generally, initial beliefs that are arbitrarily close to the inflation target equilibrium can result in complex economic dynamics, resulting in welfare-reducing fluctuations. On the contrary, central bank communication of policy rules helps stabilize expectations around the inflation target equilibrium.

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Bibliographic Info

Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 342.

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Date of creation: 2008
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Handle: RePEc:fip:fednsr:342

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Keywords: Banks and banking; Central ; Monetary policy ; Inflation (Finance) ; Inflation targeting ; Disclosure of information;

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References

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  1. Fabio Milani, 2005. "Expectations, Learning and Macroeconomic Persistence," Macroeconomics, EconWPA 0510022, EconWPA.
  2. George W. Evans & Seppo Honkapohja, 2003. "Policy Interaction, Expectations and the Liquidity Trap," University of Oregon Economics Department Working Papers, University of Oregon Economics Department 2003-33, University of Oregon Economics Department, revised 06 Jul 2004.
  3. Orphanides, Athanasios & Williams, John C., 2007. "Robust monetary policy with imperfect knowledge," Working Paper Series, European Central Bank 0764, European Central Bank.
  4. James Bullard & Kaushik Mitra, 2002. "Learning about monetary policy rules," Working Papers, Federal Reserve Bank of St. Louis 2000-001, Federal Reserve Bank of St. Louis.
  5. George Evans & Eran Guse & Seppo Honkapohja, 2007. "Liquidity Traps, Learning and Stagnation," Kiel Working Papers 1341, Kiel Institute for the World Economy.
  6. Stefano Eusepi & Bruce Preston, 2010. "Central Bank Communication and Expectations Stabilization," American Economic Journal: Macroeconomics, American Economic Association, vol. 2(3), pages 235-71, July.
  7. Jess Benhabib & Stephanie Schitt-Grohe & Martin Uribe, 2002. "Backward-Looking Interest-Rate Rules, Interest-Rate Smoothing, and Macroeconomic Instability," PIER Working Paper Archive 03-005, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania, revised 14 Feb 2003.
  8. Bullard, James & Cho, In-Koo, 2005. "Escapist policy rules," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 29(11), pages 1841-1865, November.
  9. Jess Benhabib & Stephanie Schmitt-Grohe & Martin Uribe, 1998. "The perils of Taylor Rules," Departmental Working Papers, Rutgers University, Department of Economics 199831, Rutgers University, Department of Economics.
  10. Evans, George W & Honkapohja, Seppo, 2008. "Expectations, Learning and Monetary Policy: An Overview of Recent Rersearch," CEPR Discussion Papers, C.E.P.R. Discussion Papers 6640, C.E.P.R. Discussion Papers.
  11. Bruce Preston, 2005. "Learning about Monetary Policy Rules when Long-Horizon Expectations Matter," International Journal of Central Banking, International Journal of Central Banking, International Journal of Central Banking, vol. 1(2), September.
  12. Jess Benhabib & Stephanie Schmitt-Grohe & Martin Uribe, 1999. "Monetary Policy and Multiple Equilibria," Departmental Working Papers, Rutgers University, Department of Economics 199914, Rutgers University, Department of Economics.
  13. Jess Benhabib & Stephanie Schmitt-Grohe & Martin Uribe, 2000. "Avoiding Liquidity Traps," Departmental Working Papers, Rutgers University, Department of Economics 199925, Rutgers University, Department of Economics.
  14. Lars E.O. Svensson, 2003. "Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others," NBER Working Papers 10195, National Bureau of Economic Research, Inc.
  15. Gauti B. Eggertsson & Michael Woodford, 2004. "Policy Options in a Liquidity Trap," American Economic Review, American Economic Association, American Economic Association, vol. 94(2), pages 76-79, May.
  16. Bennett T. McCallum, 2000. "Theoretical Analysis Regarding a Zero Lower Bound on Nominal Interest Rates," NBER Working Papers 7677, National Bureau of Economic Research, Inc.
  17. Marcet, Albert & Nicolini, Juan Pablo, 1998. "Recurrent Hyperinflations and Learning," CEPR Discussion Papers, C.E.P.R. Discussion Papers 1875, C.E.P.R. Discussion Papers.
  18. Eusepi, Stefano, 2007. "Learnability and monetary policy: A global perspective," Journal of Monetary Economics, Elsevier, Elsevier, vol. 54(4), pages 1115-1131, May.
  19. Evans, George W & Honkapohja, Seppo, 1995. "Local Convergence of Recursive Learning to Steady States and Cycles in Stochastic Nonlinear Models," Econometrica, Econometric Society, Econometric Society, vol. 63(1), pages 195-206, January.
  20. James Bullard, 1991. "Learning equilibria," Working Papers, Federal Reserve Bank of St. Louis 1991-004, Federal Reserve Bank of St. Louis.
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