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Constrained Discretion and Central Bank Transparency

  • Francesco Bianchi

    ()

    (Department of Economics, Duke University)

  • Leonardo Melosi

    ()

    (Federal Reserve Bank of Chicago)

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 inflation stabilization and periods during which the emphasis on inflation stabilization is reduced. When the central bank only engages in short deviations from active monetary policy, inflation 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 inflation 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 inflation 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 Penn Institute for Economic Research, Department of Economics, University of Pennsylvania in its series PIER Working Paper Archive with number 13-031.

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Length: 37 pages
Date of creation: 01 Oct 2012
Date of revision:
Handle: RePEc:pen:papers:13-031
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