Uncertainty in the monetary transmission mechanism

6.1 Uncertainty in the monetary transmission mechanism

In our basic model, in setting the monetary instrument m in (3.20) so as to expect to achieve its target for inflation the Central Bank faces only additive error e in the velocity shock ν = u + e (as shown in (3.2) and the subsequent paragraph). Certainty equivalence applies (Senegas and Vilmunen, 1999). However, a more complicated case arises when the uncertainty is multiplicative, Brainard (1967) uncertainty. In this case

(3.2’) and

y = b ( m *) − π + ν , where b = 1 + g

E C , 0 ( g ) = 0 or E C , 0 [ b ( m ) ] = m *, E C , 0 ( b ⋅ g ) = 0 .

(6.1) Under multiplicative uncertainty, the Central Bank is no longer certain about the

effects of changing its instrument, and the margin of errors will also be dependent on policy. A common way to analyse this is not to assume that the Central Bank operates directly on the money supply but that it uses an interest rate to try to achieve the monetary target. Its monetary control can thus be imperfect (Lippi, 1999; Schellekens, 1998; Senegas and Vilmunen, 1999).

Multiplicative uncertainty implies both that expected inflation will be higher and that its variance will be higher. Schellekens (1998) therefore suggests that multiplicative uncertainty actually leads to a more ‘conservative’ monetary policy and hence tends to reduce any problem of credibility that the Central Bank might have. However, the increased variance will mean that the policy-maker is likely to

be less active in setting policy than under the case of certainty. If the additive and be less active in setting policy than under the case of certainty. If the additive and

Senegas and Vilmunen (1999) show that there is an important distinction in the effect if the multiplicative uncertainty is common knowledge among both the Central Bank and the private sector. ‘[T]he impact of uncertainty is not invariant with respect to the informational structure of the monetary policy … which underlies it.’ (p.25). Hence revealing the nature of the uncertainty can help in reducing the cost of monetary policy on society.

In terms of the model we used above, if the private sector and the Central Bank do not share a common view about E(y | m) then setting m will no longer give a clear signal of the value of π *. This alters the set of alternative variables that the Central Bank needs to publish in order to convey its aims and private information. Announcing the expected value of the monetary policy instrument is no longer effective in informing the private sector of the aims of the Central

Bank’s policy and disclosing an unconditional inflation forecast is needed to achieve this. Another (essentially equivalent) alternative would be to publish the model used to set the monetary policy instrument. The Central Bank would in effect need to publish E C,0 [b(m*)] which could enable the private sector to calculate the implied goals of the announced policy.

Of course the way that the uncertainty creeps in will not just be through uncertainty about the parameters of the relationships but about the data themselves. Even the price series, which in most countries is not revised, is only an imperfect measure of the underlying variable. This is not just because of the underlying biases in the series (Boskin et al, 1998) but because it does not give an exact picture of the ‘underlying’ or ‘trend’ inflation that Central Banks normally try to target (Mayes and Chapple, 1995a). Although this introduces an additional source of uncertainty it will still be multiplicative as in the case of parameter uncertainty. Since both forms of multiplicative uncertainty can occur simultaneously, we would therefore have to handle not just their variance but their covariance as well, which could increase or diminish their combined effect

depending upon the circumstances. 16