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Central bank communication and expectations stabilization

  • Eusepi, Stefano

    (Federal Reserve Bank of New York)

  • Preston, Bruce

    (Columbia University)

This paper analyzes the value of communication in the implementation of monetary policy. The central bank is uncertain about the current state of the economy. Households and firms do not have a complete economic model of the determination of aggregate variables, including nominal interest rates, and must learn about their dynamics using historical data. When the central bank implements optimal policy, the Taylor principle is not sufficient for macroeconomic stability: for all reasonable parameterizations self-fulfilling expectations are possible. To mitigate this instability, three communication strategies are contemplated: i) communicating the precise details of the monetary policy -- that is, the variables and coefficients; ii) communicating just the variables on which monetary policy decisions are conditioned; and iii) communicating the inflation target. The first two strategies restore the Taylor principle as a sufficient condition for stabilizing expectations. In contrast, in economies with persistent shocks, communicating the inflation target fails to protect against expectations driven fluctuations. These results underscore the importance of communicating the systematic component of current and future monetary policy decisions: announcing an inflation target is not enough to stabilize expectations -- one must also announce how this target will be achieved.

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Article provided by Federal Reserve Bank of San Francisco in its journal Proceedings.

Volume (Year): (2007)
Issue (Month): March ()
Pages: 1-43

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Handle: RePEc:fip:fedfpr:y:2007:x:1
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  1. Stefano Eusepi & Bruce Preston, 2008. "Stabilizing expectations under monetary and fiscal policy coordination," Staff Reports 343, Federal Reserve Bank of New York.
  2. Stefano Eusepi & Bruce Preston, 2007. "Central Bank Communication and Expectations Stabilization," NBER Working Papers 13259, National Bureau of Economic Research, Inc.
  3. Preston, Bruce, 2006. "Adaptive learning, forecast-based instrument rules and monetary policy," Journal of Monetary Economics, Elsevier, vol. 53(3), pages 507-535, April.
  4. Alan S. Blinder, 1999. "Central Banking in Theory and Practice," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262522608, June.
  5. Bruce Preston, 2003. "Learning about monetary policy rules when long-horizon expectations matter," FRB Atlanta Working Paper No. 2003-18, Federal Reserve Bank of Atlanta.
  6. Mauro Roca, 2010. "Transparency and Monetary Policy with Imperfect Common Knowledge," IMF Working Papers 10/91, International Monetary Fund.
  7. Stefano Eusepi & Bruce Preston, 2011. "Expectations, Learning, and Business Cycle Fluctuations," American Economic Review, American Economic Association, vol. 101(6), pages 2844-72, October.
  8. Preston, Bruce, 2008. "Adaptive learning and the use of forecasts in monetary policy," Journal of Economic Dynamics and Control, Elsevier, vol. 32(11), pages 3661-3681, November.
  9. Ferrero, Giuseppe, 2007. "Monetary policy, learning and the speed of convergence," Journal of Economic Dynamics and Control, Elsevier, vol. 31(9), pages 3006-3041, September.
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