Parameter Uncertainty and Inflation Dynamics in a Model with Asymmetric Central Bank Preferences

This paper exploits the Lucas’ (1973) signal extraction model to study the effect of uncertainty in the output-inflation trade-off on inflation, using a monetary model with asymmetric central bank preferences over inflation and output. We show that the implication of the uncertainty is two-fold: firstly, it causes the interaction of output and volatility of monetary policy to influence inflation movements so that, higher volatility in monetary policy causes inflation to rise. Secondly, as suggested in an optimal rule, it causes output to contract by less whenever inflation increases above the target, and to expand by less whenever inflation is below the target. We also find that the Reserve Bank’s asymmetric aversion to inflation stabilization explains inflation movements significantly, and that the monetary authority seems to penalize more for inflationary rather than deflationary pressures. Overall, the Bank’s deflationary bias would allow for a relatively flat output-inflation trade-off, which could be helpful for economic stability.