Learning and misperception of makeup strategies

Abstract

Leading central banks have recently explored monetary policy strategies that offset past deviations of inflation from its target as an effective way to provide economic stimulus when monetary policy is constrained by the zero lower bound. Yet, the effectiveness of such makeup strategies depends on the central bank’s ability to influence agents’ expectations. We develop a model of learning about a central bank’s reaction function from observed interest rates that takes into account the limited informational content at the zero lower bound. We apply this model to study the effectiveness of switching from inflation targeting to price-level targeting. When agents learn, switching to price-level targeting at the onset of a recession does not yield the desired stabilization benefits. These benefits materialize only after the economy has been away from the zero lower bound for a sufficiently long time. We also find that temporary price-level targeting is likely to be much less effective than its permanent counterpart.