Evidence on monetary transmission and the role of imperfect information: Interest rate versus inflation target shocks

We present new empirical evidence on monetary transmission by incorporating two types of shocks – a standard temporary interest rate shock and a persistent inflation target shock. In an estimated DSGE model under imperfect information, where agents may be unable to distinguish these shocks, we find delayed Neo-Fisherian behavior in response to the persistent shock: interest rate and inflation increase, but with a lag. In an empirical VAR model that accounts for such uncertainty in identifying assumptions, we similarly find evidence for positive co-movement of interest rates and inflation in the short aftermath of the persistent shock, however, not on impact. This suggests that, when pursuing a higher inflation target, the central bank needs to engineer an expansionary monetary policy stance by lowering its real interest rate path and also initially lowering the nominal rate to stimulate inflation and inflation expectations.