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

Listed author(s):
  • 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 Staff Working Papers with number 00-10.

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Length: 37 pages
Date of creation: 2000
Handle: RePEc:bca:bocawp:00-10
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  5. Kichian, Maral, 1999. "Measuring Potential Output within a State-Space Framework," Staff Working Papers 99-9, Bank of Canada.
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  17. Faust, Jon & Svensson, Lars E O, 2001. "Transparency and Credibility: Monetary Policy with Unobservable Goals," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 42(2), pages 369-397, May.
  18. 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.
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