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Long-term debt pricing and monetary policy transmission under imperfect knowledge

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  • Stefano Eusepi
  • Marc Giannoni
  • Bruce Preston

Abstract

Under rational expectations, monetary policy is generally highly effective in stabilizing the economy. Aggregate demand management operates through the expectations hypothesis of the term structure: Anticipated movements in future short-term interest rates control current demand. This paper explores the effects of monetary policy under imperfect knowledge and incomplete markets. In this environment, the expectations hypothesis of the yield curve need not hold, a situation called unanchored financial market expectations. Whether or not financial market expectations are anchored, the private sector’s imperfect knowledge mitigates the efficacy of optimal monetary policy. Under anchored expectations, slow adjustment of interest rate beliefs limits scope to adjust current interest rate policy in response to evolving macroeconomic conditions. Imperfect knowledge represents an additional distortion confronting policy, leading to greater inflation and output volatility relative to rational expectations. Under unanchored expectations, current interest rate policy is divorced from interest rate expectations. This permits aggressive adjustment in current interest rate policy to stabilize inflation and output. However, unanchored expectations are shown to raise significantly the probability of encountering the zero lower bound constraint on nominal interest rates. The longer the average maturity structure of the public debt, the more severe is the constraint.

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Bibliographic Info

Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 547.

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Date of creation: 2012
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Handle: RePEc:fip:fednsr:547

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Keywords: Monetary policy ; Rational expectations (Economic theory) ; Interest rates ; Inflation (Finance);

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  1. Stefano Eusepi & Bruce Preston, 2010. "Debt, Policy Uncertainty and Expectations Stabilization," CAMA Working Papers 2010-20, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  2. Klaus Adam & Albert Marcet, 2011. "Internal Rationality, Imperfect Market Knowledge and Asset Prices," CEP Discussion Papers dp1068, Centre for Economic Performance, LSE.
  3. Bruce Preston & Stefano Eusepi, 2011. "The maturity structure of debt, monetary policy and expectations stabilization," 2011 Meeting Papers 1287, Society for Economic Dynamics.
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Cited by:
  1. Justiniano, Alejandro & Primiceri, Giorgio E. & Tambalotti, Andrea, 2013. "The Effects of the Saving and Banking Glut on the U.S. Economy," Working Paper Series WP-2013-17, Federal Reserve Bank of Chicago, revised 29 Nov 2013.
  2. Stefano Eusepi & Bruce Preston, 2013. "Fiscal foundations of inflation: imperfect knowledge," Staff Reports 649, Federal Reserve Bank of New York.
  3. Molnár, Krisztina & Santoro, Sergio, 2014. "Optimal monetary policy when agents are learning," European Economic Review, Elsevier, vol. 66(C), pages 39-62.

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