Policy Design with Private Sector Skepticism in the Textbook New Keynesian Model

How should policy be optimally designed when a monetary authority faces a private sector that is skeptical about policy announcements and makes inferences about the monetary authority’s ability to follow through on policy plans from economic data? To provide an answer to this question, we extend the standard New Keynesian macroeconomic model to include imperfect inflation control and Bayesian learning by private agents about whether the monetary authority is a committed type (capable of following through on announced plans) or an alternative type (producing higher and more volatile inflation). We find that the optimal pattern of inflation management depends critically on how skeptical the private sector is and how it views the alternative monetary authority whether the latter is just mechanically more inflationary or if it would mimic the committed monetary authority’s actions.