Survey_Hoeberichts_2002

Abstract

In this paper, we present a monetary policy game in which the central bank has a private forecast of supply and demand shocks. The public needs to form its inflationary expectations and can make use of central bank announcements. However, because of the credibility problem that the central bank faces, the public will not believe a precise announcement. By extending the arrangement proposed by Garfinkel and Oh (1995) to a model that includes private information about both demand and supply shocks, we investigate the feasibility of making imprecise credible announcements concerning the rate of inflation. We use a simple model with aggregate demand and aggregate supply, where monetary policy aims to stabilize the rate of inflation around a target (normalized at zero) and output around an ambitious target that is higher than the natural rate. The central bank can perfectly control the nominal interest rate. Through the nominal interest rate it can influence the real interest rate (in the short run, when inflationary expectations are fixed) and aggregate demand. The central bank has an imperfect private forecast about aggregate demand and supply shocks. Stein (1989) uses the same methodology in a model with private information regarding the exchange rate target. For the further analysis, we assume that the public just knows the distribution of the shocks and we disregard the central bank’s forecast error. In the linear-quadratic framework that we present here, certainty equivalence holds and therefore both the central bank and the public can act as if the central bank’s forecast were perfect. Conceptually, however, the presence of forecast errors is essential. Without forecast errors, the central bank’s forecasts could be verified ex-post and cheating by the central bank would be revealed.