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Long-Term Debt Pricing and Monetary Policy Transmission under Imperfect Knowledge

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  • Giannoni, Marc
  • Preston, Bruce
  • Eusepi, Stefano

Abstract

Under rational expectations monetary policy is generally highly effective in stabilizing the economy. Aggregate demand management operates through the expectations hypothesis of the term structure --- anticipated movements in future short-term interest rates control current demand. This paper explores the effects of monetary policy under imperfect knowledge and incomplete markets. In this environment the expectations hypothesis of the yield curve need not hold, a situation called unanchored financial market expectations. Whether or not financial market expectations are anchored, private sector imperfect knowledge mitigates the efficacy of optimal monetary policy. Under anchored expectations, slow adjustment of interest-rate beliefs limits scope to adjust current interest-rate policy in response to evolving macroeconomic conditions. Imperfect knowledge represents an additional distortion confronting policy, leading to greater inflation and output volatility relative to rational expectations. Under unanchored expectations, current interest-rate policy is divorced from interest-rate expectations. This permits aggressive adjustment in current interest-rate policy to stabilize inflation and output. However, unanchored expectations are shown to raise significantly the probability of encountering the zero lower bound constraint on nominal interest rates. This constraint is more severe the longer is the average maturity structure of the public debt.

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  • Giannoni, Marc & Preston, Bruce & Eusepi, Stefano, 2012. "Long-Term Debt Pricing and Monetary Policy Transmission under Imperfect Knowledge," CEPR Discussion Papers 8845, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:8845
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    Cited by:

    1. Stefano Eusepi & Bruce Preston, 2018. "Fiscal Foundations of Inflation: Imperfect Knowledge," American Economic Review, American Economic Association, vol. 108(9), pages 2551-2589, September.
    2. Alejandro Justiniano & Giorgio E. Primiceri & Andrea Tambalotti, 2013. "The Effects of the Saving and Banking Glut on the U.S. Economy," NBER Chapters, in: NBER International Seminar on Macroeconomics 2013, pages 52-67, National Bureau of Economic Research, Inc.
    3. Honkapohja, Seppo & Evans, George W. & Mitra, Kaushik, 2016. "Expectations, Stagnation and Fiscal Policy," CEPR Discussion Papers 11428, C.E.P.R. Discussion Papers.
    4. Molnár, Krisztina & Santoro, Sergio, 2014. "Optimal monetary policy when agents are learning," European Economic Review, Elsevier, vol. 66(C), pages 39-62.
    5. Piero Ferri & Fabio Tramontana, 2018. "Debt Persistence in a Deflationary Environment: A Regime-Switching Model," Computational Economics, Springer;Society for Computational Economics, vol. 52(2), pages 421-442, August.

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    More about this item

    Keywords

    Expectations hypothesis of the yield curve; Expectations stabilization; Long debt; Optimal monetary policy; Transmission of monetary policy;
    All these keywords.

    JEL classification:

    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles

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