Permanent and Transitory Policy Shocks in a VAR with Asymmetric Information

Sharon Kozicki and Peter Tinsley

No 844, Computing in Economics and Finance 1999 from Society for Computational Economics

Abstract: This paper illustrates that conclusions regarding the size of monetary policy contributions to historical movements in financial variables and economic activity depend importantly on the dynamic specification of agent expectations. In both the financial press and in small macroeconomic models, the short-term interest rate is often interpreted as a sufficient indicator of current monetary policy. However, in a world with uncertainty and asymmetric information, long-horizon perceptions are also important in descriptions of policy transmissions with forward-looking agents. These perceptions include both the averages of expected nominal short rates which, under the expectations hypothesis, are embedded in the borrowing rates of firms and households, and agent perceptions of the long-run policy target for inflation that condition ex ante real rates and multi-period price and wage contracts. The standard class of mean-reverting VARs makes two key assumptions: the inflation target of monetary policy is assumed constant over the period being analyzed and the inflation target is assumed known by all economic agents. Because the target and perceived target are assumed to be constant and equal, long-horizon expectations are independent of short-run policy. Consequently, all monetary policy actions are transient and monetary policy appears to contribute only modestly to postwar fluctuations in bond rates and economic activity. This paper proposes a second class of models that admits shifting inflation targets and shifting long-horizon expectations. This class assumes that the inflation target is not known by economic agents, so that agents must form perceptions about the inflation target. The perceived target may vary over time and need not equal the inflation target. This class of models admits two types of policy shocks: permanent shifts in the inflation target and transitory perturbations of the short-term real rate. Because agents do not observe the true target, they cannot distinguish permanent and transitory policy shocks in the short run. As a result, the transmission mechanism works differently in this class of empirical models. In particular, because errors in agent predictions of short-run policy decisions can influence long-horizon expectations, policy actions have larger and more prolonged effects that estimated in the first class of VARs.

Date: 1999-03-01
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