The Informational Effect of Monetary Policy and the Case for Policy Commitment

I explore how asymmetric information between the central bank and the private sector changes the optimal conduct of monetary policy. I build a New Keynesian model in which private agents have imperfect information about underlying shocks, while the central bank has perfect information. In this environment, private agents extract information about the underlying shocks from the central bank’s interest-rate decisions. This informational effect weakens the direct effect of monetary policy: When the central bank adjusts the interest rate to offset the effects of underlying shocks, the interest rate also reveals information about the realization of underlying shocks. Because private agents have more precise information about the shocks and consequently react more aggressively to it, the economy becomes harder to stabilize with monetary policy. I show that committing to the optimal state-contingent policy rule alleviates this problem by controlling the information revealed through the interest rate.