Working Paper: CEPR ID: DP3763
Authors: Alex Cukierman; Francesco Lippi
Abstract: This Paper characterizes endogenous monetary policy when policymakers are uncertain about the extent to which movements in output and inflation are due to changes in potential output or to cyclical demand and cost shocks. We refer to this informational limitation as the ?information problem? (IP). Main results of the Paper are: 1. Policy is likely to be excessively loose (restrictive) for some time when there is a large decrease (increase) in potential output in comparison to a full information benchmark. This provides a partial but unified explanation for the inflation of the seventies and the price stability of the nineties. 2. Errors in forecasting potential output and the output gap are generally serially correlated. 3. A quantitative assessment, based on an empirical model of the US economy developed by Rudebusch and Svensson (1999) indicates that, during and following periods of large changes in potential output, the IP significantly affects the dynamics of inflation and output. 4. The increase in the Fed?s conservativeness between the seventies and the nineties, and a more realistic appreciation of the uncertainties surrounding potential output in the second period, imply that the IP problem had a stronger impact in the seventies than in the nineties.
Keywords: filtering; inflation; monetary policy; output gap; potential output
JEL Codes: E50
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| misinterpretation of potential output (E23) | inappropriate policy responses (E65) |
| forecast errors in potential output (E37) | current policy decisions (E60) |
| serial correlation in forecast errors (C22) | current policy decisions (E60) |
| shocks to potential output (E23) | serial correlation in forecast errors (C22) |
| changes in Federal Reserve's conservativeness (E52) | changes in policy effectiveness (F68) |
| better understanding of potential output uncertainties (D89) | changes in policy effectiveness (F68) |