This paper analyzes the value of communication in the implementation of monetary policy. The central bank is uncertain about the current state of the economy. Households and firms are uncertain about the statistical properties of aggregate variables, including nominal interest rates, and must learn about their dynamics using historical data. Given these uncertainties, when the central bank implements optimal policy, the Taylor principle is not sufficient for macroeconomic stability: for reasonable parameterizations self-fulfilling expectations are possible. To mitigate this instability, three communication strategies are contemplated: i) communicating the precise details of the monetary policy -- that is, the variables and coefficients; ii) communicating only the variables on which monetary policy decisions are conditioned; and iii) communicating the inflation target. The first two strategies restore the Taylor principle as a sufficient condition for stabilizing expectations. In contrast, in economies with persistent shocks, communicating the inflation target fails to protect against expectations driven fluctuations. These results underscore the importance of communicating the systematic component of monetary policy strategy: announcing an inflation target is not enough to stabilize expectations -- one must also announce how this target will be achieved.
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
13259.
Length: Date of creation: Jul 2007 Date of revision: Handle: RePEc:nbr:nberwo:13259
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Find related papers by JEL classification: D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
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