Pitfalls of Monetary Policy Under the Incomplete Information: Imprecise Indicators and Real Indeterminacy

Bank of Italy Discussion Paper No. 488

36 Pages Posted: 24 Apr 2004

Date Written: March 2004

Abstract

The paper examines the link between the precision of the available monetary policy indicators and the determinacy of equilibrium in a forward-looking macroeconomic model with partial information and an optimizing central bank. When the information on endogenous variables is not precise enough, the central bank acts too timidly; there is a possibility of self-fulfilling fluctuations in inflation and output. It is argued that, unless they are very precise, projections of output or inflation over the relevant horizon cannot be the only criterion for determining monetary policy actions. Rules which include a sufficient reaction to nominal variables may be necessary to supply an anchor for prices, even when the policymaker intends to consider all relevant information. Appointing a "conservative" central banker may also induce a less timid response to signs of inflation or deflation, even when their interpretation is difficult. In contrast, relying too much on measures of exogenous variables, such as potential output, can be counter-productive, because it could induce an attitude that is not responsive enough to inflation or deflation.

Keywords: Monetary policy, information variables, incomplete information

JEL Classification: E52, E58

Suggested Citation

Gaiotti, Eugenio, Pitfalls of Monetary Policy Under the Incomplete Information: Imprecise Indicators and Real Indeterminacy (March 2004). Bank of Italy Discussion Paper No. 488, Available at SSRN: https://ssrn.com/abstract=535163 or http://dx.doi.org/10.2139/ssrn.535163

Eugenio Gaiotti (Contact Author)

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184
Italy
+39 06 4092 2718 (Phone)
+39 06 4792 3723 (Fax)

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