Permanent and Transitory Policy Shocks in an Empirical Macro Model with Asymmetric Information

shocks.

2 The model

As demonstrated in Kozicki and Tinsley (2002), shifts in the perceived inflation target,
imperfect policy credibility, and time-variation in the persistence of inflation appear to be
important empirical properties of U.S. inflation. The motivation of the current paper is to
specify a simple dynamic macro model that can generate these key empirical features.

Two issues influenced the selection of a model with essentially a VAR-like structure.
First, good empirical fit was seen as essential to providing a realistic assessment of the
economic significance of shifting inflation targets and asymmetric information. Second,
replication of observed dynamic interactions is important for examining policy transmission
and long-run forecasts.

The selected specification is a bit more general than a standard VAR. As with traditional
models, dynamic interactions among deviations of variables from their natural rates are
captured in a linear time-series structure. However, whereas standard models implicitly
assume that the natural rates of variables are constant and known, the current model is
augmented to allow for shifts of the inflation target and asymmetric policy information.²
Kozicki and Tinsley (2002) estimated a perceived inflation target series from a similar
VAR-like model with shifting endpoints, but did not distinguish between target shifts and
perceived target shifts.

The asymmetric information assumption implies that the inflation target is not known
by the private sector.³ Even if the target were to be announced, the model assumes that
²The term “natural rate” is used to refer to the long-run equilibrium or attractor of a variable. The
term “anchor” appears to be traditionally used in literature to denote a nominal natural rate, and the terms
“steady-state” and “mean” often imply constants.

³ The source of asymmetric information in this study is lack of knowledge on the part of the private
sector about the level and evolution of the inflation target, and about transitory and permanent policy
shocks. Other formulations of asymmetric information include private sector uncertainty about policymaker
preferences over real activity versus inflation as in Cukierman and Meltzer (1986) and Tetlow and von zur
Muehlen (2001), and different models of the transmission mechanism or other aspects of model specification

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