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Rational Ambiguity and Monitoring the Central Bank

  • Maria Demertzis
  • Andrew Hughes Hallet

In this paper we examine the consequences of having a Central Bank whose preferences are state contingent. This has been identified in the literature as a Central Bank that is 'rationally inattentive' or 'constructively ambiguous'. The new feature in this paper is that we show how the private sector is likely to react. There are two possibilities: the public can form rational expectations and internalise the uncertainty about the Central Bank's preferences in full. Alternatively, and if this process of internalisation is costly, it can form a 'best' guess regarding those preferences and use that. This implies an equivalence strategy applied to the preference parameters. As those parameters enter the decisions nonlinearly, a systematc error emerges. We examine the magnitude of the resulting error in ination and output, following the assumption of certainty equivalence. Under all reasonable levels of uncertainty this error turns out to be small but it involves trading a deation bias against the cost of gathering the information needed for the full rational expectations solution.

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File URL: http://www.dnb.nl/binaries/research%20memorandum%20wo%20no%20759_tcm46-146039.pdf
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Paper provided by Netherlands Central Bank, Research Department in its series WO Research Memoranda (discontinued) with number 759.

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Length: 13 pages
Date of creation: May 2004
Date of revision:
Handle: RePEc:dnb:wormem:759
Contact details of provider: Postal: Postbus 98, 1000 AB Amsterdam
Web page: http://www.dnb.nl/en/

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  1. 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.
  2. Hansen, Lars Peter & Sargent, Thomas J & Tallarini, Thomas D, Jr, 1999. "Robust Permanent Income and Pricing," Review of Economic Studies, Wiley Blackwell, vol. 66(4), pages 873-907, October.
  3. Hughes Hallett, A. J., 1984. "On alternative methods of generating risk sensitive decision rules," Economics Letters, Elsevier, vol. 16(1-2), pages 37-44.
  4. 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.
  5. Jordi Galí & Tommaso Monacelli, 2004. "Monetary policy and exchange rate volatility in a small open economy," Economics Working Papers 835, Department of Economics and Business, Universitat Pompeu Fabra.
  6. M. Demertzis & A. Hughes Hallet, 2002. "Central Bank Transparency in Theory and Practice," WO Research Memoranda (discontinued) 704, Netherlands Central Bank, Research Department.
  7. Muscatelli, Anton, 1998. "Optimal Inflation Contracts and Inflation Targets with Uncertain Central Bank Preferences: Accountability through Independence?," Economic Journal, Royal Economic Society, vol. 108(447), pages 529-42, March.
  8. Demertzis, Maria & Hughes Hallett, Andrew, 2003. "Three Models of Imperfect Transparency in Monetary Policy," CEPR Discussion Papers 4117, C.E.P.R. Discussion Papers.
  9. Hughes Hallett, A. J., 1979. "Computing revealed preferences and limits to the validity of quadratic objective functions for policy optimization," Economics Letters, Elsevier, vol. 2(1), pages 27-32.
  10. Sibert, Anne, 2001. "Monetary Policy With Uncertain Central Bank Preferences," CEPR Discussion Papers 3113, C.E.P.R. Discussion Papers.
  11. Jon Faust & Lars E.O. Svensson, 1999. "The Equilibrium Degree of Transparency and Control in Monetary Policy," NBER Working Papers 7152, National Bureau of Economic Research, Inc.
  12. Hallett, A. J. Hughes, 1984. "Optimal stockpiling in a high-risk commodity market the case of copper," Journal of Economic Dynamics and Control, Elsevier, vol. 8(2), pages 211-238, November.
  13. Petra M. Geraats, 2002. "Central Bank Transparency," Economic Journal, Royal Economic Society, vol. 112(483), pages 532-565, November.
  14. Sims, Christopher A., 2003. "Implications of rational inattention," Journal of Monetary Economics, Elsevier, vol. 50(3), pages 665-690, April.
  15. Lucas, Robert Jr., 1972. "Expectations and the neutrality of money," Journal of Economic Theory, Elsevier, vol. 4(2), pages 103-124, April.
  16. Lucas, Robert E, Jr, 1973. "Some International Evidence on Output-Inflation Tradeoffs," American Economic Review, American Economic Association, vol. 63(3), pages 326-34, June.
  17. Julio J. Rotemberg & Michael Woodford, 1998. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy: Expanded Version," NBER Technical Working Papers 0233, National Bureau of Economic Research, Inc.
  18. Walsh, Carl E, 1999. "Announcements, Inflation Targeting and Central Bank Incentives," Economica, London School of Economics and Political Science, vol. 66(262), pages 255-69, May.
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