By Leonardo Melosi
We develop a DSGE model in which the policy rate signals to price setters the central bank’s view about macroeconomic developments. The model is estimated with likelihood methods on a U.S. data set that includes the Survey of Professional Forecasters as a measure of price setters’ inflation expectations. We find that the model fits the data better than a prototypical New Keynesian DSGE model because the signaling effects of monetary policy help the model account for the run-up in inflation expectations in the 1970s. The estimated model with signaling effects delivers large and persistent real effects of monetary disturbances even though the average duration of price contracts is fairly short. While the signaling effects do not substantially alter the transmission of technology shocks, they bring about deflationary pressures in the aftermath of positive demand shocks. The signaling effects of monetary policy have contributed (i ) to heightening inflation expectations in the 1970s, (ii ) to raising inflation and to exacerbating the recession during the first years of Volcker’s monetary tightening, and (iii ) to subduing inflation and to stimulating economic activity from 1991 through 2007.
The model’s premise is that the central bank is more informed than the rest of the economy. Thus anything the central bank does is a signal about the true state of the economy, and the other economic agents observe and act on it. This is welfare improving, and could be even more so if the central bank could be credibly announcing the true state of the economy, and I am not sure you need the model’s price rigidities to get this result. As recent evidence shows, it is not that easy for the central bank to be that informed. That would likely make the model’s results less pronounced, and if the central bank is really confused could lead to welfare losses. But these are my conjectures.