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

activity. In the long-run, all variables return to their initial levels. In the time-varying
model, monetary policy partially accommodates the increase in inflation due to the supply
shock by allowing the inflation target to increase. The output gap turns negative in the
near-term as a consequence of the supply shock. Policy eases to avoid the negative output
response as occurs in the model with the constant target. The easier policy reverses the
negative output effect. Inflation, the federal funds rate, and the long-term interest rate
gradually approach a new higher level as the private sector learns about the new higher
target. The level to which they converge is 0.77 times the size of the initial shock.

Responses to term premium shocks are shown in Figure 7. This shock behaves like a
liquidity demand shock. In particular, the shock may reflect the implications of an increased
demand for funds on the part of producers who anticipate a future increase in sales. The
rise in long-term interest rates correctly precedes the increase in output, which also leads
to a tightening of policy. By this interpretation, the term premium shock act as a sales
expectations shock or a credit demand shock.

Figure 8 shows the impulse responses to a transitory policy shock. Responses are less
persistent in the time-varying model. The higher smoothing parameter in the estimated
policy rule of the constant model leads to a more gradual reversal of the initial policy shock.
In both models, tighter monetary policy leads to weaker economic activity, followed by a
decline in inflation. The long-term interest rate is higher in the short run, reflecting the
immediate increase in the funds rate. With weaker activity and lower inflation, policy eases
and the long rate also declines below initial levels (again only slightly).

The response of inflation to a transitory policy shock exhibits a price puzzle in the
constant model, but not in the time-varying model. This is partially explained by the
downward adjustment of the perceived target in response to the policy shock. Not knowing
with certainty whether the tighter policy is due to a transitory shock or a reduction in
the inflation target, private sector agents put some weight on the latter possibility and the

24

<<   24   25   26   27   28   29   30   >>

More intriguing information