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Constrained Discretion and Central Bank Transparency

  • Francesco Bianchi
  • Leonardo Melosi

We develop a theoretical framework to quantitatively assess the general equilibrium effects and welfare implications of central bank reputation and transparency. Monetary policy alternates between periods of active infl‡ation stabilization and periods during which the emphasis on infl‡ation stabilization is reduced. When the central bank only engages in short deviations from active monetary policy, infl‡ation expectations remain anchored and the model captures the monetary approach described as constrained discretion. However, if the central bank deviates for a prolonged period of time, agents gradually become pessimistic about future monetary policy, the disanchoring of in‡flation expectations occurs, and uncertainty rises. Reputation determines the speed with which agents’' pessimism accelerates once the central bank starts deviating. When the model is fitted to U.S. data, we find that the Federal Reserve can accommodate contractionary technology shocks for up to five years before infl‡ation expectations take off. Increasing transparency would improve welfare by anchoring agents’' expectations. Gains from transparency are even more sizeable for countries whose central banks have weak reputation.

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Paper provided by Duke University, Department of Economics in its series Working Papers with number 13-13.

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Length: 38
Date of creation: 2013
Date of revision:
Handle: RePEc:duk:dukeec:13-13
Contact details of provider: Postal: Department of Economics Duke University 213 Social Sciences Building Box 90097 Durham, NC 27708-0097
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