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Uncertainty and the Signaling Channel of Monetary Policy

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  • Jenny Tang

    (Harvard University)

Abstract

This paper studies optimal monetary policy in an environment where policy actions provide a signal of economic fundamentals to imperfectly informed agents. I derive the optimal discretionary policy in closed form and show that, in contrast to the perfect information case, the signaling channel leads the policymaker to be tougher on inflation. The strength of the signaling effect of policy depends on relative uncertainty levels. As the signaling effect strengthens, the optimal policy under discretion approaches that under commitment to a forward-looking linear rule, thereby decreasing the stabilization bias. This contributes to the central bank finding it optimal to withhold its additional information from private agents. Under a general linear policy rule, inflation and output forecasts can respond positively to a positive interest rate surprise when the signaling channel is strong. This positive response is the opposite of what standard perfect information New Keynesian models predict and it matches empirical patterns found by Romer and Romer (2000) and Campbell, Evans, Fisher, and Justiniano (2012). In addition, I substantiate the existence of a signaling channel by providing new empirical evidence supporting the predicted interaction between uncertainty and the responses of inflation forecasts to interest rate surprises.

Suggested Citation

  • Jenny Tang, 2014. "Uncertainty and the Signaling Channel of Monetary Policy," 2014 Meeting Papers 1316, Society for Economic Dynamics.
    • Handle: RePEc:red:sed014:1316
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    References listed on IDEAS

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    More about this item

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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