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Signaling in monetary policy near the zero lower bound

  • Sergio Salas EMAIL logo and Javier Nuñez
Published/Copyright: July 11, 2018
The B.E. Journal of Macroeconomics
From the journal The B.E. Journal of Macroeconomics Volume 20 Issue 1

Abstract

What are the consequences of asymmetry of information about the future state of the economy between a benevolent Central Bank (CB) and private agents near the zero lower bound? How is the conduct of monetary policy modified under such a scenario? We propose a game theoretical signaling model, where the CB has better information than private agents about a future shock hitting the economy. The policy rate itself is the signal that conveys information to private agents in addition to its traditional role in the monetary transmission mechanism. We find that only multiple “pooling equilibria” arise in this environment, where a CB privately forecasting a contraction will most likely follow a less expansionary policy compared to a complete information context, in order to avoid making matters worse by revealing bad times ahead. On the other hand, a CB privately forecasting no contraction is most likely to distort its complete information policy rate, the consequences of which are welfare detrimental. However, this is necessary because deviating from the pooling policy rate would be perceived by private agents as an attempt to mislead them into believing that a contraction is not expected, which would be even more harmful for society.

Keywords: monetary policy; signaling; zero lower bound
JEL Classification: E58; C72

A Appendix

In this appendix I study a flexible price economy, where the CB maintains i0 throughout period 0 and there is no uncertainty, with θ0 and θ1 being the productivity levels for periods 0 and 1 respectively.

Environment

As in the main model, households are indexed by j and each produce a given variety ℓ. Taking as given Pt and i0, HH j maximize:

(50)uj=u(c0j)+βu(c1j)

subject to:

(51)P0c0j+Bj=P0(ℓ)y0(ℓ),  y0(ℓ)=θ0n0j
(52)P1c1j=(1+i0)Bj+P1(ℓ)y1(ℓ),  y1(ℓ)=θ1n1j.

Choosing Pt(ℓ),ctj,yt(ℓ) and ntj, where the price level and demand for variety ℓ are given by:

(53)Pt=[∫01Pt(ℓ)1−ηdℓ]11−η,  ctj(ℓ)=(Pt(ℓ)Pt)−ηctj

where ctj(ℓ) is demand of variety ℓ by HH j.

Definition of equilibrium

A (monopolistic) competitive equilibrium is a price level Pt and an interest rate i0 such that:

  • HH maximize utility (50) subject to the constraints (51)

  • Markets clear:

    (54)Goods market clears:  ct(ℓ)≡∫01ctj(ℓ)dj=yt(ℓ)
    (55)Bonds market clears:  ∫01Bjdj=0

Solution

The intra-temporal problem of how to set prices can be written for HHs as maximizing real income from the production of variety ℓ:

(56)maxPt(ℓ),ntℓPt(ℓ)Ptyt(ℓ)

subject to:

(57)yt(ℓ)=ct(ℓ),   yt(ℓ)=θtntj,   0≤ntj≤1.

where ct(ℓ) is the market demand for variety ℓ:

(58)ct(ℓ)≡∫01ctj(ℓ)dj=(Pt(ℓ)Pt)−η∫01ctjdj≡(Pt(ℓ)Pt)−ηct

and ∫01ctjdj≡ct is defined as aggregate consumption.

Using (58), HH’s problem can be written as:

(59)maxPt(ℓ)(Pt(ℓ)Pt)1−ηct,  subject to:  ntj≡(Pt(ℓ)Pt)−ηctθt≤1

Let λt be the multiplier for the constraint in (59). The K-K-T conditions are:

(60)Pt(ℓ)Pt=ηη−1λtθt,  λt[1−(Pt(ℓ)Pt)−ηctθt],  λt≥0

By way of contradiction it is straightforward to show that ntj<1 cannot be optimal. If λt = 0 then Pt(ℓ) = 0 but the iso-elastic demand for ℓ implies that demand for product ℓ is infinite at that price. This clearly violates the restriction that ntj≤1, hence ntj=1. Then with flexibility of prices Pt(ℓ) = Pt, and market clearing in the bond market implies ct = θt. It is also immediate that ct = θt = yt(ℓ) = ct(ℓ).

As for the intertemporal consumption decision, the Euler equation in its aggregate form is:

(61)u′(θ0)=β(1+i0)P0P1u′(θ1)

A.1 Money market clearing and price level determination

Here we show that by modelling money in a simple, ad-hoc fashion, we are able to anchor the price level. First, we assume that money Mtj by each HH is demanded each period for transaction purposes:

(62)Ptctj=Mtj

We assume a given supply of money Mts. Hence in both periods, money market clearing ∫01Mtjdj=Mts should satisfy:

(63)∫01Mtjdj=Ptθt=Mts

The stock of money anchors the price level P1 = 1, by assumption. In period 0 prices are determined by Euler’s equation (61):

(64)P0=u′(θ0)β(1+i0)u′(θ1)

And given the interest rate i0, money supply in period 0 adjusts to clear the money market, using (63):

(65)M0s=θ0u′(θ0)β(1+i0)u′(θ1)

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Published Online: 2018-07-11

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  2. An empirical study on the New Keynesian wage Phillips curve: Japan and the US
  3. Risk averse banks and excess reserve fluctuations
  4. Advances
  5. Signaling in monetary policy near the zero lower bound
  6. Contributions
  7. Robust learning in the foreign exchange market
  8. Foreign official holdings of US treasuries, stock effect and the economy: a DSGE approach
  9. Discretion rather than rules? Outdated optimal commitment plans versus discretionary policymaking
  10. Agency costs and the monetary transmission mechanism
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  12. Optimal monetary policy in a model of vertical production and trade with reference currency
  13. The financial accelerator and marketable debt: the prolongation channel
  14. The welfare cost of inflation with banking time
  15. Prospect Theory and sentiment-driven fluctuations
  16. Contributions
  17. Household borrowing constraints and monetary policy in emerging economies
  18. The macroeconomic impact of shocks to bank capital buffers in the Euro Area
  19. The effects of monetary policy on input inventories
  20. The welfare effects of infrastructure investment in a heterogeneous agents economy
  21. Advances
  22. Collateral and development
  23. Contributions
  24. Financial deepening in a two-sector endogenous growth model with productivity heterogeneity
  25. Is unemployment on steroids in advanced economies?
  26. Monitoring and coordination for essentiality of money
  27. Dynamics of female labor force participation and welfare with multiple social reference groups
  28. Advances
  29. Technology and the two margins of labor adjustment: a New Keynesian perspective
  30. Contributions
  31. Changing demand for general skills, technological uncertainty, and economic growth
  32. Job competition, human capital, and the lock-in effect: can unemployment insurance efficiently allocate human capital
  33. Fiscal policy and the output costs of sovereign default
  34. Animal spirits in an open economy: an interaction-based approach to the business cycle
  35. Ramsey income taxation in a small open economy with trade in capital goods
https://doi.org/10.1515/bejm-2016-0114
Keywords for this article
monetary policy; signaling; zero lower bound

Articles in the same Issue

  1. Contributions
  2. An empirical study on the New Keynesian wage Phillips curve: Japan and the US
  3. Risk averse banks and excess reserve fluctuations
  4. Advances
  5. Signaling in monetary policy near the zero lower bound
  6. Contributions
  7. Robust learning in the foreign exchange market
  8. Foreign official holdings of US treasuries, stock effect and the economy: a DSGE approach
  9. Discretion rather than rules? Outdated optimal commitment plans versus discretionary policymaking
  10. Agency costs and the monetary transmission mechanism
  11. Advances
  12. Optimal monetary policy in a model of vertical production and trade with reference currency
  13. The financial accelerator and marketable debt: the prolongation channel
  14. The welfare cost of inflation with banking time
  15. Prospect Theory and sentiment-driven fluctuations
  16. Contributions
  17. Household borrowing constraints and monetary policy in emerging economies
  18. The macroeconomic impact of shocks to bank capital buffers in the Euro Area
  19. The effects of monetary policy on input inventories
  20. The welfare effects of infrastructure investment in a heterogeneous agents economy
  21. Advances
  22. Collateral and development
  23. Contributions
  24. Financial deepening in a two-sector endogenous growth model with productivity heterogeneity
  25. Is unemployment on steroids in advanced economies?
  26. Monitoring and coordination for essentiality of money
  27. Dynamics of female labor force participation and welfare with multiple social reference groups
  28. Advances
  29. Technology and the two margins of labor adjustment: a New Keynesian perspective
  30. Contributions
  31. Changing demand for general skills, technological uncertainty, and economic growth
  32. Job competition, human capital, and the lock-in effect: can unemployment insurance efficiently allocate human capital
  33. Fiscal policy and the output costs of sovereign default
  34. Animal spirits in an open economy: an interaction-based approach to the business cycle
  35. Ramsey income taxation in a small open economy with trade in capital goods
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