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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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  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. Troy Davig & Taeyoung Doh, 2008. "Monetary policy regime shifts and inflation persistence," Research Working Paper RWP 08-16, Federal Reserve Bank of Kansas City.
  3. Roger E.A. Farmer & Tao Zha & Daniel F. Waggoner, 2009. "Understanding Markov-Switching Rational Expectations Models," NBER Working Papers 14710, National Bureau of Economic Research, Inc.
  4. Timothy Cogley & Christian Matthes & Argia M. Sbordone, 2011. "Optimal disinflation under learning," Staff Reports 524, Federal Reserve Bank of New York.
  5. Nimark, Kristoffer, 2008. "Dynamic pricing and imperfect common knowledge," Journal of Monetary Economics, Elsevier, vol. 55(2), pages 365-382, March.
  6. Leonardo Melosi, 2011. "Public's Inflation Expectations and Monetary Policy," 2011 Meeting Papers 1151, Society for Economic Dynamics.
  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. Troy Davig & Eric M. Leeper, 2006. "Generalizing the Taylor Principle," Caepr Working Papers 2006-001, Center for Applied Economics and Policy Research, Economics Department, Indiana University Bloomington.
  9. Thomas A. Lubik & Frank Schorfheide, 2004. "Testing for Indeterminacy: An Application to U.S. Monetary Policy," American Economic Review, American Economic Association, vol. 94(1), pages 190-217, March.
  10. Christopher A. Sims & Tao Zha, 2006. "Were There Regime Switches in U.S. Monetary Policy?," American Economic Review, American Economic Association, vol. 96(1), pages 54-81, March.
  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. 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.
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Cited by:
  1. Leonardo Melosi, 2013. "Signaling Effects of Monetary Policy," PIER Working Paper Archive 13-029, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.
  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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