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Central bank communication and expectations stabilization

Eusepi, Stefano; Preston, Bruce J.

The value of communication in monetary policy is analyzed in a model in which expectations need not be consistent with central bank policy - and, therefore, "unanchored" - because agents face difficult forecasting problems. When the central bank implements optimal policy without communication, the Taylor principle is not sufficient for macroeconomic stability: expectations are unanchored and self-fulfilling expectations are possible. To mitigate this instability, three communication strategies are contemplated to ensure consistency between private forecasts and monetary policy strategy: i) communicating the precise details of the monetary policy - that is, the variables and coefficients; ii) communicating only the variables on which monetary policy decisions are conditioned; and iii) communicating the inflation target. The first two strategies restore the Taylor principle as a sufficient condition for anchoring expectations. In contrast, in economies with persistent shocks, communicating the inflation target fails to protect against expectations driven fluctuations. These results underscore the importance of communicating the systematic component of monetary policy strategy: announcing an inflation target is not enough to stabilize expectations - one must also announce how this target will be achieved.

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Academic Units
Economics
Publisher
Department of Economics, Columbia University
Series
Department of Economics Discussion Papers, 0708-10
Published Here
March 28, 2011

Notes

December 2007

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