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

interpretations share the common assumptions of asymmetric policy information and of
significant deviations of private sector long-run inflation forecasts from the true inflation
target.

Because shifts in the perceived inflation target do not always appear to coincide with
possible shifts in the inflation target of the monetary authority, asymmetric information on
the part of private sector agents and the monetary authority seems more plausible than the
standard assumption of full information. In this paper, such deviations of the perceived
target from the true target provide evidence of imperfect policy credibility, where credible
policy is defined as the equivalence of the natural rate of private sector inflation forecasts
with the inflation target of the monetary authority.

Recent macro models with shifting policy regimes include the atheoretic empirical model
of Cogley and Sargent (2003), the calibrated dynamic stochastic general equilibrium models
of Erceg and Levin (2003) and Andolfatto and Gomme (2003), and Bayesian estimates of
the DSGE models in Schorfheide (2003). Similar to learning specifications in the last two
citations, private agent learning in the current paper is based on agent responses to the
prediction error of the short-term interest rate controlled by monetary policy.

This paper reexamines evidence on the monetary transmission mechanism using a small
empirical model of the U.S. economy. The model specification admits imperfect policy
credibility by relaxing the standard assumptions of full information and a constant inflation
target. Monetary policy is summarized by a policy rule with the federal funds rate smoothly
adjusted in response to cyclical movements in economic activity, deviations of inflation from
the inflation target, inflation target shifts, and transitory policy shocks. Unlike typical
empirical models with a single policy shock, the model in this paper includes two types of
policy shocks: permanent shifts to the inflation target and transitory perturbations of the
federal funds rate. Because agents do not observe the true target, they cannot distinguish
permanent and transitory policy shocks in the short run.

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