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Parameter Uncertainty and Inflation Dynamics in a Model with Asymmetric Central Bank Preferences

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  • Laban K. Chesang

    () (Department of Economics, University of Pretoria)

  • Ruthira Naraidoo

    () (Department of Economics, University of Pretoria)

Abstract

This paper exploits the Lucas’ (1973) signal extraction model to study the effect of uncertainty in the output-inflation trade-off on inflation, using a monetary model with asymmetric central bank preferences over inflation and output. We show that the implication of the uncertainty is two-fold: firstly, it causes the interaction of output and volatility of monetary policy to influence inflation movements so that, higher volatility in monetary policy causes inflation to rise. Secondly, as suggested in an optimal rule, it causes output to contract by less whenever inflation increases above the target, and to expand by less whenever inflation is below the target. We also find that the Reserve Bank’s asymmetric aversion to inflation stabilization explains inflation movements significantly, and that the monetary authority seems to penalize more for inflationary rather than deflationary pressures. Overall, the Bank’s deflationary bias would allow for a relatively flat output-inflation trade-off, which could be helpful for economic stability.

Suggested Citation

  • Laban K. Chesang & Ruthira Naraidoo, 2014. "Parameter Uncertainty and Inflation Dynamics in a Model with Asymmetric Central Bank Preferences," Working Papers 201437, University of Pretoria, Department of Economics.
  • Handle: RePEc:pre:wpaper:201437
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    References listed on IDEAS

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    1. repec:eee:ecmode:v:67:y:2017:i:c:p:228-247 is not listed on IDEAS
    2. repec:eee:ecmode:v:67:y:2017:i:c:p:215-227 is not listed on IDEAS

    More about this item

    Keywords

    Monetary policy; Asymmetric preferences; Inflation; Uncertainty;

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination

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