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Constrained Discretion and Central Bank Transparency

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  • Francesco Bianchi

    ()
    (Department of Economics, Duke University)

  • Leonardo Melosi

    ()
    (Federal Reserve Bank of Chicago)

Abstract

We develop a theoretical framework to quantitatively assess the general equilibrium effects and welfare implications of central bank reputation and transparency. Monetary policy alternates between periods of active inflation stabilization and periods during which the emphasis on inflation stabilization is reduced. When the central bank only engages in short deviations from active monetary policy, inflation expectations remain anchored and the model captures the monetary approach described as constrained discretion. However, if the central bank deviates for a prolonged period of time, agents gradually become pessimistic about future monetary policy, the disanchoring of inflation expectations occurs, and uncertainty rises. Reputation determines the speed with which agents’ pessimism accelerates once the central bank starts deviating. When the model is fitted to U.S. data, we find that the Federal Reserve can accommodate contractionary technology shocks for up to five years before inflation expectations take off. Increasing transparency would improve welfare by anchoring agents’ expectations. Gains from transparency are even more sizeable for countries whose central banks have weak reputation.

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File URL: http://economics.sas.upenn.edu/system/files/13-031.pdf
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Bibliographic Info

Paper provided by Penn Institute for Economic Research, Department of Economics, University of Pennsylvania in its series PIER Working Paper Archive with number 13-031.

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Length: 37 pages
Date of creation: 01 Oct 2012
Date of revision:
Handle: RePEc:pen:papers:13-031

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Keywords: Bayesian learning; reputation; uncertainty; in.ation expectations; Markov-switching models; impulse response;

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References

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  1. Richard Clarida & Jordi Gali & Mark Gertler, 1998. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," NBER Working Papers 6442, National Bureau of Economic Research, Inc.
  2. Timothy Cogley & Christian Matthes & Argia M. Sbordone, 2011. "Optimal disinflation under learning," Staff Reports 524, Federal Reserve Bank of New York.
  3. Troy Davig & Eric M. Leeper, 2005. "Generalizing the Taylor Principle," NBER Working Papers 11874, National Bureau of Economic Research, Inc.
  4. Francesco Bianchi, 2010. "Regime Switches, Agents' Beliefs, and Post-World War II U.S. Macroeconomic Dynamics," Working Papers 10-39, Duke University, Department of Economics.
  5. Rodriguez-Palenzuela, Diego & Castelnuovo, Efrem & Nicoletti-Altimari, Sergio, 2003. "Definition of price stability, range and point inflation targets: the anchoring of long-term inflation expectations," Working Paper Series 0273, European Central Bank.
  6. Troy Davig & Taeyoung Doh, 2008. "Monetary policy regime shifts and inflation persistence," Research Working Paper RWP 08-16, Federal Reserve Bank of Kansas City.
  7. Christopher A. Sims & Tao Zha, 2005. "Were There Regime Switches in U.S. Monetary Policy?," Working Papers 92, Princeton University, Department of Economics, Center for Economic Policy Studies..
  8. Frank Schorfheide, 2003. "Learning and monetary policy shifts," Working Paper 2003-23, Federal Reserve Bank of Atlanta.
  9. Jordi Galí & Mark Gertler, 2007. "Macroeconomic modeling for monetary policy evaluation," Economics Working Papers 1039, Department of Economics and Business, Universitat Pompeu Fabra, revised Jul 2007.
  10. Leonardo Melosi, 2012. "Signaling effects of monetary policy," Working Paper Series WP-2012-05, Federal Reserve Bank of Chicago.
  11. Giorgio E. Primiceri, 2005. "Time Varying Structural Vector Autoregressions and Monetary Policy," Review of Economic Studies, Oxford University Press, vol. 72(3), pages 821-852.
  12. Thomas Lubik & Frank Schorfheide, 2002. "Testing for Indeterminacy:An Application to U.S. Monetary Policy," Economics Working Paper Archive 480, The Johns Hopkins University,Department of Economics, revised Jun 2003.
  13. Nimark, Kristoffer, 2008. "Dynamic pricing and imperfect common knowledge," Journal of Monetary Economics, Elsevier, vol. 55(2), pages 365-382, March.
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Cited by:
  1. Leonardo Melosi & Francesco Bianchi, 2012. "Dormant Shocks and Fiscal Virtue," 2012 Meeting Papers 44, Society for Economic Dynamics.
  2. Leonardo Melosi, 2012. "Signaling effects of monetary policy," Working Paper Series WP-2012-05, Federal Reserve Bank of Chicago.
  3. Francesco Bianchi & Cosmin Ilut, 2014. "Monetary/Fiscal Policy Mix and Agents' Beliefs," NBER Working Papers 20194, National Bureau of Economic Research, Inc.
  4. Francesco Bianchi & Leonardo Melosi, 2013. "Modeling the Evolution of Expectations and Uncertainty in General Equilibrium," Working Papers 13-14, Duke University, Department of Economics.

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