Kiel Working Papers, Kiel Institute for World Economics
No 1429:
Managing Disinflation under Uncertainty
Mewael F. Tesfaselassie and Eric Schaling
Abstract: In this paper we analyze disinflation policy when a
central bank has imperfect information about private sector inflation
expectations but learns about them from economic outcomes, which are in
part the result of the disinflation policy. The form of uncertainty is
manifested as uncertainty about the effect of past disinflation policy on
current output gap. Thus current as well as past policy actions matter for
output gap determination. We derive the optimal policy under learning (DOP)
and compare it two limiting cases---certainty equivalence policy (CEP) and
cautionary policy (CP). It turns out that under the DOP inflation stay
between the levels implied by the CEP and the CP. A novel result is that
this holds irrespective of the initial level of inflation. Moreover, while
at high levels of inherited inflation the DOP moves closer to the CEP, at
low levels of inherited inflation the DOP resembles the CP
Keywords: Learning, Inflation Expectations, Disinflation Policy, Separation Principle, Kalman Filter, Optimal Control; (follow links to similar papers)
JEL-Codes: C53,; E42,; E52,; F33; (follow links to similar papers)
22 pages, June 2008
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