Working Paper

Constrained Discretion and Central Bank Transparency

Abstract: We develop and estimate a general equilibrium model in which monetary policy can deviate from active inflation stabilization and agents face uncertainty about the nature of these deviations. When observing a deviation, agents conduct Bayesian learning to infer its likely duration. Under constrained discretion, only short deviations occur: Agents are confident about a prompt return to the active regime, macroeconomic uncertainty is low, welfare is high. However, if a deviation persists, agents? beliefs start drifting, uncertainty accelerates, and welfare declines. If the duration of the deviations is announced, uncertainty follows a reverse path. For the U.S. transparency lowers uncertainty and increases welfare.

Keywords: Bayesian learning; reputation; uncertainty; expectations; Markov-switching models; impulse responses;

JEL Classification: C11; D83; E52;

Bibliographic Information

Provider: Federal Reserve Bank of Chicago

Part of Series: Working Paper Series

Publication Date: 2014-07-01

Number: WP-2014-16

Pages: 55 pages