CFS Working Paper No. 2003/41
Permanent and Transitory Policy Shocks in an
Empirical Macro Model with Asymmetric Information
Sharon Kozicki and P.A. Tinsley
This version: October 28, 2003
Abstract:
Despite a large literature documenting that the efficacy of monetary policy depends on how
inflation expectations are anchored, many monetary policy models assume: (1) the inflation
target of monetary policy is constant; and, (2) the inflation target is known by all economic
agents. This paper proposes an empirical specification with two policy shocks: permanent
changes to the inflation target and transitory perturbations of the short-term real rate. The
public sector cannot correctly distinguish between these two shocks and, under incomplete
learning, private perceptions of the inflation target will not equal the true target. The paper
shows how imperfect policy credibility can affect economic responses to structural shocks,
including transition to a new inflation target - a question that cannot be addressed by many
commonly used empirical and theoretical models. In contrast to models where all monetary
policy actions are transient, the proposed specification implies that sizable movements in
historical bond yields and inflation are attributable to perceptions of permanent shocks in
target inflation.
JEL Classification: E43, E52, D82, D83
Keywords: transmission mechanism, learning, policy credibility, time-varying natural rate,
shifting endpoint, inflation target, term structure of interest rates
An earlier version was presented at the 2003 conference on “Expectations, Learning, and Monetary Policy”
sponsored by the Center for Financial Studies, the Deutsche Bundesbank, and the Journal of Economic
Dynamics and Control in Eltville, Germany, the 1999 American Economic Association annual meetings, the
1999 Conference on Computing in Economics and Finance of the Society of Computational Economics, the
Federal Reserve Board, and the Federal Reserve Bank of Kansas City. We received many constructive comments
from Michael Binder, William Branch, Alex Cukierman, and Reinhard Tietz for which we are very grateful.
Thanks also to Matthew Cardillo for excellent research assistance.
Authors’ addresses are: Federal Reserve Bank of Kansas City, 925 Grand Boulevard, Kansas City, MO, 64198
USA, [email protected]; and Faculty of Economics and Politics, University of Cambridge, Cambridge CB3
9DD, UK, [email protected].
The views expressed are those of the authors and do not necessarily represent those of the Federal Reserve
Bank of Kansas City or the Federal Reserve Board.