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

In the model, the inflation goal of policy is assumed only to be known by the monetary
authority, although the observable policy instrument provides noisy information about the
target. Private sector agents must form perceptions of the inflation goal of policy and these
perceptions influence nominal price setting. The model specification admits a possibly
shifting inflation target of monetary policy as well as a perceived inflation target that also
may vary over time. This framework can apply to countries with announced inflation targets
as well as to those without, since announced targets may not be fully credible.

Simulations of the model illustrate how imperfect policy credibility can affect 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 model generates sizable monetary policy contributions to historical
fluctuations in inflation and bond yields attributable to permanent target shocks. A
consequence of the estimated learning structure is that the perceived inflation target remains
elevated well into the 1980s, holding up bond rates long after the inflation target and
inflation have retreated.

Taylor (1980) and Meyer and Webster (1982) examine the implications of a permanent
policy shock in models with a money growth rule and learning behavior on the part of the
private sector. These papers examined the behavior of inflation without references to actual
or perceived inflation targets or long-term interest rates. Effects of changes in perceived
inflation targets on long-term bond rates are analyzed in Fuhrer (1996), Huh and Lansing
(1998), and Kozicki and Tinsley (2001a, 2001b). Whereas Fuhrer’s analysis assumes shifts
in policy regimes are instantly known to private agents, the remaining studies incorporate
asymmetric information assumptions. The current paper provides explicit contrasts between
empirical estimates of the time-varying inflation target and private sector perceptions of the
inflation target.

Following the seminal work of Sargent (1993) and Evans and Honkapohja (2001), models

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