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Managing Beliefs about Monetary Policy under Discretion?

Optimal monetary policy becomes tricky when the central bank has better information than the public: Policy does not only affect economic fundamentals, but also people’s beliefs. For a general class of widely studied DSGE models, this paper derives the optimal discretionary policy under hidden information. Illustrated with a simple New Keynesian model, the introduction of hidden information has striking effects on discretionary policies: Policy losses are better under hidden information than under full transparency. Looking at Markov-perfect policies excludes reputational mechanisms via history dependent strategies. Under full transparency, discretion policies are then myopic, since a current policymaker cannot influence future decisions. But imperfect information adds public beliefs as a distinct, endogenous state variable. Managing beliefs connects the actions of policymakers such that they realize the inflationary consequences of expansionary policies. The optimal policy shares similarities with those from commitment models. Additionally, disinflations are pursued more vigorously the larger the credibility problems from hidden information. Optimal policy also responds to belief shocks, which shift public perceptions about fundamentals even when those fundamentals are unchanged.

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Paper provided by Swiss National Bank, Study Center Gerzensee in its series Working Papers with number 08.02.

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Length: 75 pages
Date of creation: Nov 2008
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Handle: RePEc:szg:worpap:0802
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