Can Ignorance Make Central Banks Behave?: Instrument Uncertainty and the Inflationary Bias Problem

This paper presents a model in which "instrument uncertainty"—that is, an uncertain mapping from monetary policy to macroeconomic outcomes—may mitigate the inflationary bias problem that arises when efficient monetary policy rules are time-inconsistent. If the relation between monetary policy and macroeconomic outcomes is uncertain, the private sector has an incentive to scrutinize the past for clues about this relationship. This learning creates a link between past government behavior and present inflation expectations that the government can exploit to enhance its credibility. The model implies that the two conventional arguments for simple rules in monetary policy—one stressing the central bank's poor forecasting abilities and the other stressing the perils of discretion—may work at cross-purposes. Moreover, it provides an explanation of the cyclical behavior of inflation due to political cycles and of the correlation between the level and variance of inflation.