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Inflationary Sentiments and Monetary Policy Communcation

  • Leonardo Melosi

    (London Business School)

  • Francesco Bianchi

    (Duke University)

We develop a DSGE model in which the conduct of monetary policy influences agents' inflationary sentiments, defined as waves of pessimism about how aggressively the central bank will react to inflation in the future. Monetary policy alternates periods of active inflation stabilization (i.e., active regime) and periods during which the emphasis is mainly on output stabilization (i.e., passive regime). Deviations from the active regime can be long or short lasting. When observing passive monetary policy, agents do not know the nature of the deviation and have to learn which type of passive regime is in place. As the central bank deviates from the active monetary policy for a longer and longer period, inflationary sentiments progressively spread among agents, who get increasingly convinced that the central bank might have switched to the long-lasting passive regime. Mounting inflationary sentiments have the effect to make the inflation-output gap trade-off worse and to depress private sector's welfare. When the model is calibrated to U.S. data, we find that inflationary sentiments sluggishly rise as the Federal Reserve deviates from active monetary policy. Such a dynamic for sentiments implies that (i) inflation drifts up for several years in response to a cost-push shock and (ii) the Federal Reserve has a large leeway in accommodating this type of shocks. Increasing the transparency of the Federal Reserve is found to improve welfare by anchoring inflationary sentiments. Gains from transparency are even more sizeable in periods when the persistence of shocks is high and for countries whose central bank has failed establishing a strong commitment to keeping inflation under control.

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Paper provided by Society for Economic Dynamics in its series 2012 Meeting Papers with number 893.

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Date of creation: 2012
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Handle: RePEc:red:sed012:893
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  1. Giorgio E. Primiceri, 2005. "Time Varying Structural Vector Autoregressions and Monetary Policy," Review of Economic Studies, Oxford University Press, vol. 72(3), pages 821-852.
  2. Christopher A. Sims & Tao Zha, 2004. "Were there regime switches in U.S. monetary policy?," Working Paper 2004-14, Federal Reserve Bank of Atlanta.
  3. Bianchi, Francesco, 2008. "Regime switches, Agents’ Beliefs, and Post-World War II U.S. Macroeconomic Dynamics," MPRA Paper 24251, University Library of Munich, Germany, revised 19 Jan 2010.
  4. Rodriguez-Palenzuela, Diego & Castelnuovo, Efrem & Nicoletti-Altimari, Sergio, 2003. "Definition of price stability, range and point inflation targets: the anchoring of long-term inflation expectations," Working Paper Series 0273, European Central Bank.
  5. Frank Schorfheide, 2003. "Learning and monetary policy shifts," Working Paper 2003-23, Federal Reserve Bank of Atlanta.
  6. Timothy Cogley & Christian Matthes & Argia M. Sbordone, 2011. "Optimal disinflation under learning," Staff Reports 524, Federal Reserve Bank of New York.
  7. Leonardo Melosi, 2011. "Public's Inflation Expectations and Monetary Policy," 2011 Meeting Papers 1151, Society for Economic Dynamics.
  8. Kristoffer Nimark, 2007. "Dynamic Pricing and Imperfect Common Knowledge," RBA Research Discussion Papers rdp2007-12, Reserve Bank of Australia.
  9. Troy Davig & Eric M. Leeper, 2007. "Generalizing the Taylor Principle," American Economic Review, American Economic Association, vol. 97(3), pages 607-635, June.
  10. Roger E.A. Farmer & Daniel F. Waggoner & Tao Zha, 2009. "Understanding Markov-switching rational expectations models," Working Paper 2009-05, Federal Reserve Bank of Atlanta.
  11. Thomas Lubik & Frank Schorfheide, 2002. "Testing for Indeterminacy:An Application to U.S. Monetary Policy," Economics Working Paper Archive 480, The Johns Hopkins University,Department of Economics, revised Jun 2003.
  12. Troy Davig & Taeyoung Doh, 2014. "Monetary Policy Regime Shifts and Inflation Persistence," The Review of Economics and Statistics, MIT Press, vol. 96(5), pages 862-875, December.
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