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

perceived inflation target moves down. In the long-run, all variables return to their initial
levels in both models. In the time-varying model, agents correctly learn that the policy
shock was only transitory.

The final two simulations examine responses to permanent target shocks and to
expectations shocks. These experiments could only be run in the time-varying target model
because in the other model the target and perceived target are constrained to be constant.
Figure 9 reports impulse responses to a permanent target shock that increases the inflation
target by one percentage point. Policy immediately eases strongly, because with the increase
in the target, inflation is now too low. In the absence of an immediate inflation response,
the lower nominal funds rate implies a lower real funds rate and leads to a small decline in
long-term rates and to an expansion of output. Unexpectedly easy policy leads private sector
agents gradually to believe that the inflation target may be higher and the perceived inflation
target increases. Inflation increases with higher aggregate demand and the increase in the
perceived target. Initially, the increase in the perceived target leads the increase in inflation.
As inflation increases towards the target, policy becomes less expansionary. Eventually the
output gap returns to zero. However, the perceived target gradually converges towards the
new inflation target as does inflation. The long-term interest rate and the federal funds
rate also fully incorporate the permanent increase in inflation and converge to a level that
is one percentage point higher than initially.

Responses to a shock to the perceived target are shown in Figure 10. This expectational
shock occurs in the absence of a change in the target. Output increases initially because an
increase in the perceived target in the absence of an increase in inflation is like a reduction
in inflationary pressures which stimulates aggregate demand. Excess demand then leads to
rising inflation. The funds rate is increased to bring down inflation and higher inflation, and
the long rate follows suit. With tighter policy the economic activity slows, and inflation
declines. Tighter than expected policy leads private sector agents to revise down their

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