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Probing Potential Output: Monetary Policy, Credibility, and Optimal Learning under Uncertainty

  • Yetman, James

The effective conduct of monetary policy is complicated by uncertainty about the level of potential output, and thus about the size of the monetary policy response that would be sufficient to achieve the targeted inflation rate. One possible response to such uncertainty is for the monetary authority to "probe," interpreted here as actively using its policy response to learn about the level of potential output. Monetary authorities have put significant emphasis in recent years on attaining credibility for their policy objectives. These steps have anchored inflation expectations to the target of the monetary authority more firmly. I consider a simple calibrated model in the Canadian context and examine the relationship between credibility and optimal probing. I find that, for plausible parameter values, the optimal amount of probing is small and varies little with credibility. Only for low levels of credibility or unrealistically large levels of uncertainty or volatility does the optimal policy with probing diverge significantly from a policy that ignores learning. Even then, the optimal amount of probing diminishes as credibility rises.

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Paper provided by Bank of Canada in its series Working Papers with number 00-10.

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Length: 37 pages
Date of creation: 2000
Date of revision:
Handle: RePEc:bca:bocawp:00-10
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  1. Bertocchi, Graziella & Spagat, Michael, 1993. "Learning, experimentation, and monetary policy," Journal of Monetary Economics, Elsevier, vol. 32(1), pages 169-183, August.
  2. Kichian, Maral, 1999. "Measuring Potential Output within a State-Space Framework," Working Papers 99-9, Bank of Canada.
  3. Volker Wieland, 1999. "Monetary policy, parameter uncertainty and optimal learning," Finance and Economics Discussion Series 1999-48, Board of Governors of the Federal Reserve System (U.S.).
  4. Dupasquier, Chantal & Guay, Alain & St-Amant, Pierre, 1999. "A Survey of Alternative Methodologies for Estimating Potential Output and the Output Gap," Journal of Macroeconomics, Elsevier, vol. 21(3), pages 577-595, July.
  5. Kenneth Kuttner, 1992. "Monetary policy with uncertain estimates of potential output," Economic Perspectives, Federal Reserve Bank of Chicago, issue Jan, pages 2-15.
  6. Arturo Estrella & Frederic Mishkin, 1998. "Rethinking the role of NAIRU in monetary policy: implications of model formulation and uncertainty," Research Paper 9806, Federal Reserve Bank of New York.
  7. Gordon Thiessen, 1995. "Uncertainty and the transmission of monetary policy in Canada (HERMES-Glendon Lecture) [speech]," Bank of Canada Review, Bank of Canada, vol. 1995(Summer), pages 41-58.
  8. Svensson, Lars E.O., 1997. "Inflation Targeting: Some Extensions," Seminar Papers 625, Stockholm University, Institute for International Economic Studies.
  9. Frank Smets, 1998. "Output gap uncertainty: does it matter for the Taylor rule?," BIS Working Papers 60, Bank for International Settlements.
  10. Faust, J. & Svensson, L.E.O., 1998. "Transparency and Credibility: Monetary Policy with Unobservable Goals," Papers 636, Stockholm - International Economic Studies.
  11. Kendrick, David, 1982. "Caution and probing in a macroeconomic model," Journal of Economic Dynamics and Control, Elsevier, vol. 4(1), pages 149-170, November.
  12. Wieland, Volker, 2003. "Monetary Policy and Uncertainty about the Natural Unemployment Rate," CEPR Discussion Papers 3811, C.E.P.R. Discussion Papers.
  13. Robert Amano & Don Coletti & Tiff Macklem, 1999. "Monetary Rules When Economic Behaviour Changes," Cahiers de recherche CREFE / CREFE Working Papers 81, CREFE, Université du Québec à Montréal.
  14. Srour, Gabriel, 1999. "Inflation Targeting under Uncertainty," Technical Reports 85, Bank of Canada.
  15. Glenn D. Rudebusch & Lars E. O. Svensson, 1998. "Policy rules for inflation targeting," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
  16. Caplin, Andrew & Leahy, John, 1996. "Monetary Policy as a Process of Search," American Economic Review, American Economic Association, vol. 86(4), pages 689-702, September.
  17. Cukierman, Alex & Meltzer, Allan H, 1986. "A Theory of Ambiguity, Credibility, and Inflation under Discretion and Asymmetric Information," Econometrica, Econometric Society, vol. 54(5), pages 1099-1128, September.
  18. Balvers, Ronald J & Cosimano, Thomas F, 1994. "Inflation Variability and Gradualist Monetary Policy," Review of Economic Studies, Wiley Blackwell, vol. 61(4), pages 721-38, October.
  19. Duguay, Pierre, 1994. "Empirical evidence on the strength of the monetary transmission mechanism in Canada: An aggregate approach," Journal of Monetary Economics, Elsevier, vol. 33(1), pages 39-61, February.
  20. St-Amant, P. & van Norden, S., 1997. "Measurement of the Output Gap: A Discussion of Recent Research at the Bank of Canada," Technical Reports 79, Bank of Canada.
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