Central Bank Commitment under Imperfect Information∗

I study optimal monetary policy when both the central bank and the private sector have imperfect information about the underlying economy. I model forward guidance as providing the central bank’s own forecast on optimal policy conditional on its own imperfect information. When the private sector has rational expectation, it is able to infer the imperfect information held by the central bank from the forward guidance policy. The central bank can either commit to the forward guidance policy, or re-optimize when accurate information becomes available in later stage. I demonstrate the policy trade-off for central bank commitment under imperfect information: re-optimization closes the output gap, but also makes the aggregate price level deviate further away from zero, as re-optimization leads to additional uncertainty in firms’ pricing decisions, whose effect is amplified through higher order beliefs. ∗I am deeply indebted to Michael Woodford for his invaluable guidance and support over the course of this project. I would also like to thank Andres Drenik, Jennifer La’O, and Jon Steinsson for their insights and helpful advice. I also greatly benefited from comments and discussion with Patrick Bolton, Frederic Mishkin, Jose Scheinkman, Stephanie Schmitt-Grohe, Martin Uribe, and other seminar participants in the Economics Department of Columbia University.. All errors are mine. †Department of Economics, 420 W. 118th St., New York, NY 10027 Email: [email protected]