Learning, expectations and monetary policy

DateFebruary 2021
AuteurPablo GARCIA

The uncertainty that surrounds public perceptions of central bank policy matters for business cycle dynamics. An increasing number of empirical studies document the contractionary effects of increases in monetary policy uncertainty in developed economies.
I offer a theoretical explanation for these contractionary effects. To this end, I present a New Keynesian model in which private agents have limited information about the central bank’s reac-tion function. The latter alternates between periods of active inflation stabilization and periods of passive inflation stabilization. Each quarter, private agents estimate the parameters of the current monetary regime by combining what they see happening in the economy with their own past beliefs.
This belief structure accounts for the contractionary effects of increases in monetary policy uncertainty. Spikes in uncertainty about the current monetary regime obscure the likely path of future nominal interest rates, and hence, of the marginal product of capital. This unpredictability encourages private agents to defer investment decisions until additional information becomes available. The fall in investment then hinders economic activity through the standard channels: a decline in aggregate demand, and the prospect of a protracted period of unusually low capital stock.
In addition, I explore how uncertainty about the current monetary policy regime affects the transmission of monetary policy shocks. By softening the link between fundamentals and equi-librium prices and allocations, learning renders the economy less responsive to monetary policy.
Changes in the monetary policy regime in the model capture a constrained discretion strategy [Bernanke and Mishkin (1997)], followed by the Federal Reserve and other central banks. This allows the central bank some flexibility to de-emphasize inflation stabilization to pursue alter-native short-term goals, limiting cyclical swings in resource utilization, while retaining a strong commitment to keeping inflation low and stable.

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