Constrained Discretion and Central Bank Transparency

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 engages in only 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 become pessimistic about future monetary policy and uncertainty gradually 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, the Federal Reserve is found to benefit from strong reputation and large flexibility in responding to inflationary shocks. Increasing transparency would improve welfare by anchoring agents' expectations.