Optimal Monetary Policy with Uncertain Private Sector Foresight

Central banks operate in a world in which there is substantial uncertainty regarding the transmission of its actions to the economy because of uncertainty regarding the formation of private-sector expectations. We model private sector expectations using a finite horizon planning framework: Households and firms have limited foresight when deciding spending, saving, and pricing decisions. In this setting, contrary to standard New Keynesian (NK) models, we show that "an inflation scares problem" for the central bank can arise where agents' longer-run inflation expectations deviate persistently from a central bank's inflation target. We formally characterize optimal time-consistent monetary policy when there is uncertainty about the planning horizons of private sector agents and a risk of inflation scares. We show how risk management considerations modify the optimal leaning-against-the-wind principle in the NK literature with a novel, additional preemptive motive to avert inflation scares. We quantify the importance of such risk management considerations during the recent post-pandemic inflation surge.

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Publication Details

Journal
Finance and Economics Discussion Series
Published
2024-08-01
DOI
https://doi.org/10.17016/feds.2024.059
Citations
1
Primary Topic
Monetary Policy and Economic Impact
Type
article
Field-Weighted Citation Impact
0.83
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article

Optimal Monetary Policy with Uncertain Private Sector Foresight

Christopher Gust, David López‐Salido
1 citations
Finance and Economics Discussion Series
Monetary Policy and Economic Impact
0.83
article

Optimal Monetary Policy with Uncertain Private Sector Foresight

Christopher Gust, David López‐Salido
article en
1 citations

Abstract

Central banks operate in a world in which there is substantial uncertainty regarding the transmission of its actions to the economy because of uncertainty regarding the formation of private-sector expectations. We model private sector expectations using a finite horizon planning framework: Households and firms have limited foresight when deciding spending, saving, and pricing decisions. In this setting, contrary to standard New Keynesian (NK) models, we show that "an inflation scares problem" for the central bank can arise where agents' longer-run inflation expectations deviate persistently from a central bank's inflation target. We formally characterize optimal time-consistent monetary policy when there is uncertainty about the planning horizons of private sector agents and a risk of inflation scares. We show how risk management considerations modify the optimal leaning-against-the-wind principle in the NK literature with a novel, additional preemptive motive to avert inflation scares. We quantify the importance of such risk management considerations during the recent post-pandemic inflation surge.

Finance and Economics Discussion Series(2024-059)
Federal Reserve (US), Federal Reserve Board of Governors (US)
Openalex Percentile: Top 24%
Monetary Policy and Economic Impact
0.83
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