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Uncertainty about Perceived Inflation Target and Monetary Policy

July 2007
Kosuke Aoki*1
Takeshi Kimura*2

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Abstract

We analyse the interaction between private agents' uncertainty about inflation target and the central bank's data uncertainty. In our model, private agents update their perceived inflation target and the central bank estimates unobservable economic shocks as well as the perceived inflation target. Under those two uncertainties, the learning process of both private agents and the central bank causes higher order beliefs to become relevant, and this mechanism is capable of generating high persistence and volatility of inflation even though the underlying shocks are purely transitory. We also find that the persistence and volatility become smaller as the inflation target becomes more credible, that is, the private agents' uncertainty about inflation target (and hence the bank's data uncertainty) diminishes.

The authors are grateful for comments from Nicoletta Baniti, Martin Bodenstein, Anton Braun, Shinichi Fukuda, Bernardo Guimaraes, Athanasios Orphanides, Nobuyuki Oda, Pedro Teles, Hiroshi Ugai, seminar participants at Bank of Canada, Bank of England, Bank of Japan, Bank of Portugal, BIS, Cambridge, ESSIM 2005, LSE, University of Tokyo, Hitotsubashi, Kobe, Osaka and Tohoku Universities, as well as participants at the Joint Deutsche Bundesbank/Federal Reserve Bank of Cleveland Conference. The authors also thank Naohisa Hirakata for his excellent research assistance. Aoki thanks hospitality of the Bank of Japan. The paper represents the views and analysis of the authors and should not be thought to represent those of the Bank of Japan.

  • *1 London School of Economics and Political Science
    E-mail: k.aoki@lse.ac.uk
  • *2 Research and Statistics Department, Bank of Japan
    E-mail: takeshi.kimura@boj.or.jp

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