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

learning algorithm that places greater weight on more recent observations of the funds rate
expectations error:

π^P(t +1)=π^P(t) - δ(rt - r_t^e)+uP,t,                         (4)

where u_P,t is an expectations shock. After substituting for the funds rate expectations error
from (3), perceived target learning satisfies:

π^P(t +1)=(1- δγπ)π^P(t)+δγππ^T(t) - δur,t +uP,t.                (5)

For non-zero δ, the target and perceived target are cointegrated, so that for 0 <δγ_π < 1
and in the absence of future shocks, the perceived target will gradually adjust towards
the target.⁵ This adjustment comes, not from direct knowledge of the target, but from
information about the gap between the target and perceived target that is contained in the
market prediction error for the funds rate.

3EstimationResults

Quarterly data from 1960 through 2001 was used for the empirical analysis. Inflation
is measured as the quarterly percent change in the chain-price index for core personal
consumption expenditures. The output gap is measured as the percent deviation between
quarterly real GDP and Congressional Budget Office estimates of quarterly potential real
GDP. The vintage of these data is the first quarter of 2003. The quarterly averages of the
federal funds rate and of the constant maturity 10-year yield on U.S. Treasury bonds are
used as the short-term policy rate and the long-term interest rate, respectively. All series
are expressed at annual rates. The output and inflation series are seasonally adjusted.

The model to be estimated includes:

⁵ However, as long as monetary policy is subject to transitory shocks, the perceived target will continue
to fluctuate about the true target.

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