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Expectations and the Central Banker: Making Decisions the Market Expects to See? [revised]

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  • Edward Kutsoati
  • Sharun Mukand

Abstract

Reflecting on his experience as a central banker, Alan Blinder (1998) observed that “while I never saw a single case of a central banker succumbing to the temptation that so worried Kydland and Prescott, I often witnessed central bankers sorely tempted to deliver the policy that the markets expected or demanded.” In this paper we develop a framework that examines conditions under which a central banker is tempted to “follow the markets.” In doing so, we explore the implications of increased market ‘consensus’ on the practice of monetary policy and show that ineciency in policymaking is most likely precisely when there is a very high consensus that economic fundamentals are weak or strong. In addition, our results also shed light on (i) why interest rates may not be high enough even when the central bank’s information suggests a rise in asset prices may be due to ‘bubble’ shock; (ii) why a central banker may be reluctant to adopt a loose monetary policy even when investors seem to be very pessimistic about the path of future output; and (iii) why, contrary to conventional models, we sometimes observe an upward revision of private sector’s forecasts of inflation when the central bank tightens its monetary policy. The results have implications for transparency of monetary policy.

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Bibliographic Info

Paper provided by Department of Economics, Tufts University in its series Discussion Papers Series, Department of Economics, Tufts University with number 0418.

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Date of creation: 2004
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Handle: RePEc:tuf:tuftec:0418

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  1. Glenn D. Rudebusch & Lars E. O. Svensson, 1998. "Policy rules for inflation targeting," Working Papers in Applied Economic Theory 98-03, Federal Reserve Bank of San Francisco.
  2. Svensson, Lars E.O. & Faust, John, 1998. "Transparency and Credibility: Monetary Policy with Unobservable Goals," Seminar Papers 636, Stockholm University, Institute for International Economic Studies.
  3. Richard Clarida & Jordi Galí & Mark Gertler, 1997. "The science of monetary policy: A new Keynesian perspective," Economics Working Papers 356, Department of Economics and Business, Universitat Pompeu Fabra, revised Apr 1999.
  4. Robert J. Gordon, 1996. "The Time-Varying NAIRU and its Implications for Economic Policy," NBER Working Papers 5735, National Bureau of Economic Research, Inc.
  5. Dolado, Juan J. & Maria-Dolores, Ramon & Naveira, Manuel, 2005. "Are monetary-policy reaction functions asymmetric?: The role of nonlinearity in the Phillips curve," European Economic Review, Elsevier, vol. 49(2), pages 485-503, February.
  6. Eric T. Swanson, 2004. "Federal Reserve transparency and financial market forecasts of short-term interest rates," Finance and Economics Discussion Series 2004-06, Board of Governors of the Federal Reserve System (U.S.).
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  8. Barro, Robert J. & Gordon, David B., 1983. "Rules, discretion and reputation in a model of monetary policy," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 101-121.
  9. Glenn Rudebusch, 2000. "Assessing Nominal Income Rules for Monetary Policy with Model and Data Uncertainty," Econometric Society World Congress 2000 Contributed Papers 0065, Econometric Society.
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  13. Matthew B. Canzoneri, 1983. "Monetary policy games and the role of private information," International Finance Discussion Papers 249, Board of Governors of the Federal Reserve System (U.S.).
  14. Athanasios Orphanides, 1998. "Monetary policy rules based on real-time data," Finance and Economics Discussion Series 1998-03, Board of Governors of the Federal Reserve System (U.S.).
  15. Tore Ellingsen & Ulf Soderstrom, 2001. "Monetary Policy and Market Interest Rates," American Economic Review, American Economic Association, vol. 91(5), pages 1594-1607, December.
  16. Douglas Staiger & James H. Stock & Mark W. Watson, 1996. "How Precise are Estimates of the Natural Rate of Unemployment?," NBER Working Papers 5477, National Bureau of Economic Research, Inc.
  17. Alex Cukierman & Anton Muscatelli, 2001. "Do Central Banks have Precautionary Demands for Expansions and for Price Stability?," Working Papers 2002_4, Business School - Economics, University of Glasgow, revised Mar 2002.
  18. David H. Romer & Christina D. Romer, 2000. "Federal Reserve Information and the Behavior of Interest Rates," American Economic Review, American Economic Association, vol. 90(3), pages 429-457, June.
  19. Alan S. Blinder, 1999. "Central Banking in Theory and Practice," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262522608, December.
  20. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
  21. Cukierman, A., 1999. "The Inflation Bias Result Revisited," Papers 38-99, Tel Aviv.
  22. Joe Peek & Eric S. Rosengren & Geoffrey M. B. Tootell, 1998. "Does the Federal Reserve have an informational advantage? you can bank on it," Working Papers 98-2, Federal Reserve Bank of Boston.
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Cited by:
  1. Lavan Mahadeva, 2007. "A model of market surprises," Bank of England working papers 327, Bank of England.

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