The Limits of Monetary Policy Under Imperfect Knowledge
The modern theory of monetary policy emphasizes the management of expectations. In New Keynesian models frequently used for policy evaluation it is well understood that it is not so much the current interest rate, but instead anticipated movements in future interest rates that are central to aggregate demand management. Movements in current and future expected interest rates are linked through arbitrage relationships. Through the appropriate choice of current interest rates, good policy seeks to have these expectations evolve in a way that achieves the most desirable short-run trade-off between inflation and the output gap. <P> An important question then is whether the efficacy of monetary policy is compromised when current interest-rate movements are not efficiently transmitted to various longer-term interest rates relevant to spending and pricing plans of agents in the economy. Is the potency of monetary policy diminished when there is imprecise control of interest-rate expectations? <P> The central focus of this paper are the consequences of imperfect knowledge for monetary control. Under rational expectations, optimal policy prescribes that the nominal interest rate should track the evolution of the natural rate of interest, which in our framework embeds (exogenous) fluctuations in productivity, propensity to work and government spending. Importantly, optimal policy under perfect knowledge can fully stabilize output gap and inflation (the well known divine coincidence). The key result of the paper is that under imperfect knowledge and learning the efficacy of monetary policy can be drastically reduced. It is shown that imperfect knowledge prevents full stabilization of output gap and inflation, even for optimal monetary policy that accounts for imperfect knowledge. More precisely, a policy-maker who knows the structure of the economy and has full information about private agents' expectations formation process will not be able to achieve full economic stability. Optimal monetary policy has the property that the evolution of beliefs is managed in exactly the right way to ensure a bounded equilibrium consistent with maximization of households' welfare. In this sense the economy is stable: it has unique bounded state-contingent evolution for all endogenous variables given bounded stochastic disturbance processes. But this does not necessarily imply that drifting beliefs are not problematic for the transmission of monetary policy. <P> Under imperfect knowledge optimal policy prescribes slow adjustments in current interest-rate policy in response to evolving macroeconomic conditions to limit excess volatility in long-term rates. Changes in current interest rates lead to revisions of beliefs about future interest rates, albeit with a lag due to learning dynamics. The revisions in beliefs in turn feedback on the state of aggregate demand in subsequent periods. Aggressive adjustment of current interest rates, which would promote full stabilization under perfect knowledge, cause excessive movements in long-rates and macroeconomic volatility. Potential instability in long-term interest rates constrains the degree to which current monetary policy can respond to evolving economic conditions. In other words the link between short-term interest setting, and the evolution of long-term interest rates is much weaker under imperfect knowledge than under rational expectations. <P> The results in the paper have two main implications for current monetary policy debate. First, the past recession is widely believed to be caused by a `demand' shock, lowering both the output-gap and inflation. However, despite the monetary stimulus provided by central banks in the form low interest rates from conventional and unconventional policies, the recovery in US and in other countries remains sluggish. Consequently monetary authorities have been criticized for `not doing enough'. This paper suggests that the observed gradual adjustment is not inconsistent with policy being set optimally once we take into account of market participants' uncertainty about economic fundamentals. Second, the paper offers an alternative rationale for gradualism in monetary policy even in normal times, as reflected by high interest smoothing coefficients that are usually found in estimated Taylor rules.
Year of publication: |
2014
|
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Authors: | Giannoni, Marc ; Preston, Bruce ; Eusepi, Stefano |
Institutions: | Society for Economic Dynamics - SED |
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