How Largely Can Commitment Beat Policy-makers’ Misperception?

Extended Abstract This paper investigates the assumption that policy-makers commit to a Taylor rule, using an inflation-unemployment dynamic model for the US economy. Our approach differs from previous work as we model policymakers’ belief as a latent variable rather than as represented by observed nominal interest rate. Our paper is based on the conjecture that policy-maker’s misperception originates from unobserved deviations of unemployment from its natural rate. We propose five processes for policy-makers’ belief under commitment to inflation and unemployment and compare them with a baseline autoregressive process without commitment. The models are: a) a time-invariant Taylor rule in which policy-makers can only observe previous inflation and unemployment; b) a time-varying Taylor rule in which policy-makers adjust their commitment each period according to available information; c) a Taylor rule in which commitment switches between high and low inflation and unemployment phases, following a Markov switching process; d) a Taylor rule in which commitment is changed as a response to different regimes in unemployment only; e) a Taylor rule with commitment adjusted according to low or high inflation regimes only. We specify a loss function derived from a constrained minimization of the divergence in inflation