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Central bank transparency and nonlinear learning dynamics

  • Stefano Eusepi

Central bank communication plays an important role in shaping market participants' expectations. This paper studies a simple nonlinear model of monetary policy in which agents have incomplete information about the economic environment. It shows that agents' learning and the dynamics of the economy are heavily affected by central bank transparency about its policy rule. A central bank that does not communicate its rule can induce "learning equilibria" in which the economy alternates between periods of deflation coupled with low output and periods of high economic activity with excessive inflation. More generally, initial beliefs that are arbitrarily close to the inflation target equilibrium can result in complex economic dynamics, resulting in welfare-reducing fluctuations. On the contrary, central bank communication of policy rules helps stabilize expectations around the inflation target equilibrium.

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Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 342.

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Date of creation: 2008
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Handle: RePEc:fip:fednsr:342
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  1. Eusepi, Stefano & Preston, Bruce, 2007. "Central bank communication and expectations stabilization," Proceedings, Federal Reserve Bank of San Francisco, issue March, pages 1-43.
  2. Lars E.O. Svensson, 2003. "Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others," NBER Working Papers 10195, National Bureau of Economic Research, Inc.
  3. Benhabib, J. & Schmitt-Grohe, S. & Uribe, M., 1998. "Monetary Policy and Multiple Equilibria," Working Papers 98-02, C.V. Starr Center for Applied Economics, New York University.
  4. George Evans & Eran Guse & Seppo Honkapohja, 2007. "Liquidity Traps, Learning and Stagnation," Kiel Working Papers 1341, Kiel Institute for the World Economy.
  5. Jess Benhabib & Stephanie Schmitt-Grohe & Martin Uribe, 2003. "Backward-looking interest-rate rules, interest-rate smoothing, and macroeconomic instability," Proceedings, Federal Reserve Bank of Cleveland, pages 1379-1423.
  6. Benhabib, J. & Schmitt-Grohe, S. & Uribe, M., 1999. "Avoiding Liquidity Traps," Working Papers 99-21, C.V. Starr Center for Applied Economics, New York University.
  7. James B. Bullard, 1991. "Learning equilibria," Working Papers 1991-004, Federal Reserve Bank of St. Louis.
  8. Athanasios Orphanides & John C. Williams, 2007. "Robust monetary policy with imperfect knowledge," Working Paper Series 2007-08, Federal Reserve Bank of San Francisco.
  9. Preston, Bruce, 2005. "Learning about Monetary Policy Rules when Long-Horizon Expectations Matter," MPRA Paper 830, University Library of Munich, Germany.
  10. Fabio Milani, 2005. "Expectations, Learning and Macroeconomic Persistence," Macroeconomics 0510022, EconWPA.
  11. James B. Bullard & In-Koo Cho, 2003. "Escapist policy rules," Working Papers 2002-002, Federal Reserve Bank of St. Louis.
  12. Albert Marcet & Juan P. Nicolini, 1995. "Recurrent hyperinflations and learning," Economics Working Papers 244, Department of Economics and Business, Universitat Pompeu Fabra, revised Nov 2001.
  13. James B. Bullard & Kaushik Mitra, 2002. "Learning about monetary policy rules," Working Papers 2000-001, Federal Reserve Bank of St. Louis.
  14. George W. Evans & Seppo Honkapohja, 2008. "Expectations, Learning, And Monetary Policy: An Overview Of Recent Research," Working Papers Central Bank of Chile 501, Central Bank of Chile.
  15. Bennett T. McCallum, 2000. "Theoretical Analysis Regarding a Zero Lower Bound on Nominal Interest Rates," NBER Working Papers 7677, National Bureau of Economic Research, Inc.
  16. George W. Evans & Seppo Honkapohja, 2003. "Policy Interaction, Expectations and the Liquidity Trap," University of Oregon Economics Department Working Papers 2003-33, University of Oregon Economics Department, revised 06 Jul 2004.
  17. Benhabib, Jess & Schmitt-Grohe, Stephanie & Uribe, Martin, 1998. "The Perils of Taylor Rules," Working Papers 98-37, C.V. Starr Center for Applied Economics, New York University.
  18. Eusepi, Stefano, 2007. "Learnability and monetary policy: A global perspective," Journal of Monetary Economics, Elsevier, vol. 54(4), pages 1115-1131, May.
  19. Gauti B. Eggertsson & Michael Woodford, 2004. "Policy Options in a Liquidity Trap," American Economic Review, American Economic Association, vol. 94(2), pages 76-79, May.
  20. Evans, George W & Honkapohja, Seppo, 1995. "Local Convergence of Recursive Learning to Steady States and Cycles in Stochastic Nonlinear Models," Econometrica, Econometric Society, vol. 63(1), pages 195-206, January.
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