Rational Ambiguity and Monitoring the Central Bank

Maria Demertzis and Andrew Hughes Hallet
Authors registered in the RePEc Author Service: Andrew Hughes Hallett ()

WO Research Memoranda (discontinued) from Netherlands Central Bank, Research Department

Abstract: In this paper we examine the consequences of having a Central Bank whose preferences are state contingent. This has been identified in the literature as a Central Bank that is `rationally inattentive' or `constructively ambiguous'. The new feature in this paper is that we show how the private sector is likely to react. There are two possibilities: the public can form rational expectations and internalise the uncertainty about the Central Bank's preferences in full. Alternatively, and if this process of internalisation is costly, it can form a `best' guess regarding those preferences and use that. This implies an equivalence strategy applied to the preference parameters. As those parameters enter the decisions nonlinearly, a systematc error emerges. We examine the magnitude of the resulting error in ination and output, following the assumption of certainty equivalence. Under all reasonable levels of uncertainty this error turns out to be small but it involves trading a deation bias against the cost of gathering the information needed for the full rational expectations solution.

Keywords: Central Bank Transparency; Certainty Equivalence; Rational Expectations; Ambiguity and Rational Inattention (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba and nep-fin
Date: 2004-05
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Working Paper: Rational Ambiguity and Monitoring the Central Bank (2004)
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