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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. James B. Bullard & Kaushik Mitra, 2002. "Learning about monetary policy rules," Working Papers 2000-001, Federal Reserve Bank of St. Louis.
  2. Jess Benhabib & Stephanie Schmitt-Grohe & Martin Uribe, 2003. "Backward-looking interest-rate rules, interest-rate smoothing, and macroeconomic instability," Working Papers 03-4, Federal Reserve Bank of Philadelphia.
  3. 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.
  4. Benhabib, Jess & Schmitt-Grohe, Stephanie & Uribe, Martin, 2001. "The Perils of Taylor Rules," Journal of Economic Theory, Elsevier, vol. 96(1-2), pages 40-69, January.
  5. George W. Evans & Seppo Honkapohja, 2004. "Policy interaction, expectations and the liquidity trap," Macroeconomics 0404033, EconWPA.
  6. Preston, Bruce, 2005. "Learning about Monetary Policy Rules when Long-Horizon Expectations Matter," MPRA Paper 830, University Library of Munich, Germany.
  7. Eusepi, Stefano, 2007. "Learnability and monetary policy: A global perspective," Journal of Monetary Economics, Elsevier, vol. 54(4), pages 1115-1131, May.
  8. George Evans & Eran Guse & Seppo Honkapohja, 2007. "Liquidity Traps, Learning and Stagnation," Kiel Working Papers 1341, Kiel Institute for the World Economy.
  9. 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.
  10. 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.
  11. 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.
  12. Athanasios Orphanides & John C. Williams, 2007. "Robust monetary policy with imperfect knowledge," Working Paper Series 2007-08, Federal Reserve Bank of San Francisco.
  13. 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.
  14. 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.
  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. Stefano Eusepi & Bruce Preston, 2007. "Central Bank Communication and Expectations Stabilization," NBER Working Papers 13259, National Bureau of Economic Research, Inc.
  17. Marcet, Albert & Nicolini, Juan Pablo, 1998. "Recurrent Hyperinflations and Learning," CEPR Discussion Papers 1875, C.E.P.R. Discussion Papers.
  18. James B. Bullard, 1991. "Learning equilibria," Working Papers 1991-004, Federal Reserve Bank of St. Louis.
  19. Fabio Milani, 2005. "Expectations, Learning and Macroeconomic Persistence," Working Papers 050608, University of California-Irvine, Department of Economics.
  20. Bullard, James & Cho, In-Koo, 2003. "Escapist policy rules," CFS Working Paper Series 2003/38, Center for Financial Studies (CFS).
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