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Inflationary Sentiments and Monetary Policy Communcation

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  • Leonardo Melosi

    (London Business School)

  • Francesco Bianchi

    (Duke University)

Abstract

We develop a DSGE model in which the conduct of monetary policy influences agents' inflationary sentiments, defined as waves of pessimism about how aggressively the central bank will react to inflation in the future. Monetary policy alternates periods of active inflation stabilization (i.e., active regime) and periods during which the emphasis is mainly on output stabilization (i.e., passive regime). Deviations from the active regime can be long or short lasting. When observing passive monetary policy, agents do not know the nature of the deviation and have to learn which type of passive regime is in place. As the central bank deviates from the active monetary policy for a longer and longer period, inflationary sentiments progressively spread among agents, who get increasingly convinced that the central bank might have switched to the long-lasting passive regime. Mounting inflationary sentiments have the effect to make the inflation-output gap trade-off worse and to depress private sector's welfare. When the model is calibrated to U.S. data, we find that inflationary sentiments sluggishly rise as the Federal Reserve deviates from active monetary policy. Such a dynamic for sentiments implies that (i) inflation drifts up for several years in response to a cost-push shock and (ii) the Federal Reserve has a large leeway in accommodating this type of shocks. Increasing the transparency of the Federal Reserve is found to improve welfare by anchoring inflationary sentiments. Gains from transparency are even more sizeable in periods when the persistence of shocks is high and for countries whose central bank has failed establishing a strong commitment to keeping inflation under control.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2012 Meeting Papers with number 893.

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Date of creation: 2012
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Handle: RePEc:red:sed012:893

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References

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  1. Francesco Bianchi, 2009. "Regime Switches, Agents’ Beliefs, and Post-World War II U.S. Macroeconomic Dynamics," 2009 Meeting Papers 198, Society for Economic Dynamics.
  2. Christopher A. Sims & Tao Zha, 2004. "Were there regime switches in U.S. monetary policy?," Working Paper 2004-14, Federal Reserve Bank of Atlanta.
  3. Troy Davig & Eric M. Leeper, 2005. "Generalizing the Taylor Principle," NBER Working Papers 11874, National Bureau of Economic Research, Inc.
  4. Farmer, Roger E.A. & Waggoner, Daniel F. & Zha, Tao, 2009. "Understanding Markov-switching rational expectations models," Journal of Economic Theory, Elsevier, vol. 144(5), pages 1849-1867, September.
  5. Taeyoung Doh & Troy Davig, 2009. "Monetary Policy Regime Shifts and Inflation Persistence," 2009 Meeting Papers 182, Society for Economic Dynamics.
  6. 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.
  7. Frank Schorfheide, 2005. "Learning and Monetary Policy Shifts," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 8(2), pages 392-419, April.
  8. Timothy Cogley & Christian Matthes & Argia M. Sbordone, 2011. "Optimal disinflation under learning," Staff Reports 524, Federal Reserve Bank of New York.
  9. Kristoffer Nimark, 2007. "Dynamic Pricing and Imperfect Common Knowledge," RBA Research Discussion Papers rdp2007-12, Reserve Bank of Australia.
  10. 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.
  11. 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.
  12. Leonardo Melosi, 2011. "Public's Inflation Expectations and Monetary Policy," 2011 Meeting Papers 1151, Society for Economic Dynamics.
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Cited by:
  1. Leonardo Melosi, 2012. "Signaling effects of monetary policy," Working Paper Series WP-2012-05, Federal Reserve Bank of Chicago.
  2. Klodiana Istrefi & Anamaria Piloiu, 2013. "Economic Policy Uncertainty, Trust and Inflation Expectations," CESifo Working Paper Series 4294, CESifo Group Munich.

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