Parameter Uncertainty and Inflation Dynamics in a Model with Asymmetric Central Bank Preferences

Laban Chesang () and Ruthira Naraidoo
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Laban Chesang: Department of Economics, University of Pretoria

No 201437, Working Papers from University of Pretoria, Department of Economics

Abstract: This paper exploits the Lucas’ (1973) signal extraction model to study the effect of uncertainty in the output-inflation trade-off on inflation, using a monetary model with asymmetric central bank preferences over inflation and output. We show that the implication of the uncertainty is two-fold: firstly, it causes the interaction of output and volatility of monetary policy to influence inflation movements so that, higher volatility in monetary policy causes inflation to rise. Secondly, as suggested in an optimal rule, it causes output to contract by less whenever inflation increases above the target, and to expand by less whenever inflation is below the target. We also find that the Reserve Bank’s asymmetric aversion to inflation stabilization explains inflation movements significantly, and that the monetary authority seems to penalize more for inflationary rather than deflationary pressures. Overall, the Bank’s deflationary bias would allow for a relatively flat output-inflation trade-off, which could be helpful for economic stability.

Keywords: Monetary policy; Asymmetric preferences; Inflation; Uncertainty (search for similar items in EconPapers)
JEL-codes: E31 E52 E58 E61 (search for similar items in EconPapers)
Pages: 30 pages
Date: 2014-08
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
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Journal Article: Parameter uncertainty and inflation dynamics in a model with asymmetric central bank preferences (2016)
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