Endogenous Monetary Policy with Unobserved Potential Output

This paper characterizes monetary policy when policymakers are uncertain about the extent to which fluctuations in output and inflation are due to changes in potential output or to cyclical demand and cost shocks. Our results suggest an explanation for the inflation of the 1970s and the price stability of the 1990s. It is shown that: (1) policy is likely to be excessively loose for some time when there is a large decrease in potential output in comparison to a full information benchmark. (2) Retrospective policy errors and errors in forecasting potential output and the output gap are generally serially correlated. (3) The increase in the Fed's conservativeness between the 1970s and the 1990s implies that the information problem had greater consequences in the former period.