Dynamics of Monetary Policy Uncertainty and the Impact on the Macroeconomy

Herro, Nicholas and Murray, James (2011): Dynamics of Monetary Policy Uncertainty and the Impact on the Macroeconomy.

Abstract

A large literature lauds the benefits of central bank transparency and credibility, but when a central bank like the U.S. Federal Reserve has a dual mandate, is not specific to the extent it targets employment versus price stability, and is not specific to the magnitude interest rates should change in response to these targets, market participants must depend largely on past data to form expectations about monetary policy. We suppose market participants estimate a Taylor-like regression equation to understand the conduct of monetary policy, which likely guides their short-run and long-run expectations. When the Federal Reserve's actions deviate from its historical targets for macroeconomic variables, an environment of greater uncertainty may be the result. We quantify this degree of uncertainty by measuring and aggregating recent deviations of the federal funds rate from econometric forecasts predicted by constant gain learning. We incorporate this measure of uncertainty into a VAR model with ARCH shocks to measure the effect monetary policy uncertainty has on inflation, output growth, unemployment, and the volatility of these variables. We find that a higher degree of uncertainty regarding monetary policy is associated with greater volatility of output growth and unemployment.

• Item Type: MPRA Paper
• Language: English
• Keywords: Uncertainty; learning; volatility; Taylor rule; vector autoregression; ARCH.
• Subjects: E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles > E32 - Business Fluctuations ; Cycles; E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles > E31 - Price Level ; Inflation ; Deflation; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E58 - Central Banks and Their Policies

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