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

The two models have similar qualitative responses to aggregate demand shocks,
transitory policy shocks and term premium shocks, but responses to the former two shocks
tend to be more persistent and larger in the constant target model. However, model
responses to aggregate supply shocks are considerably different as aggregate supply shocks
lead to target shifts in the time-varying model. Figures 5 through 8 show responses of the
two models to an aggregate demand shock, an aggregate supply (or cost push) shock, a
term premium shock, and a transitory policy shock, respectively. Responses for the model
with time-varying targets and asymmetric information are shown as the solid line in the
Figures and labeled time-varying. The short dashed lines labeled constant show responses
for the model with a known constant inflation target.

In response to a positive aggregate demand shock (Figure 5), the output gap, the
long-term interest rate and the funds rate increase immediately. Inflation increases
substantially in the constant model, but remains under control in the the time-varying
model. The muted response of inflation in the time-varying model may reflect that with
lags in inflation, policy can effectively cut off the adverse consequences of an aggregate
demand shock before inflation responds. Furthermore, because policy actions are fully
anticipated in the time-varying model, long-term inflation expectations are firmly anchored
by a perceived inflation target that does shift with the demand shock. Because of the larger
inflation response, the policy response is much more prolonged in the constant model and
long-term interest rates remain elevated for a considerable period of time. In both models
tighter monetary policy successfully slows output. In the long run, all variables return to
their initial levels.

A positive aggregate supply shock (Figure 6) leads to an immediate increase in inflation.
Responses to the shock differ considerably in the two models, however. In the constant
model, the aggregate supply shock leads to an output contraction. The federal funds rate
increases as the response to higher inflation dominates the response to weaker economic

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