Probing Potential Output: Monetary Policy, Credibility, and Optimal Learning under Uncertainty

The effective conduct of monetary policy is complicated by uncertainty about the level of potential output, and thus about the size of the monetary policy response that would be sufficient to achieve the targeted inflation rate. One possible response to such uncertainty is for the monetary authority to "probe," interpreted here as actively using its policy response to learn about the level of potential output.

Monetary authorities have put significant emphasis in recent years on attaining credibility for their policy objectives. These steps have anchored inflation expectations to the target of the monetary authority more firmly. I consider a simple calibrated model in the Canadian context and examine the relationship between credibility and optimal probing.

I find that, for plausible parameter values, the optimal amount of probing is small and varies little with credibility. Only for low levels of credibility or unrealistically large levels of uncertainty or volatility does the optimal policy with probing diverge significantly from a policy that ignores learning. Even then, the optimal amount of probing diminishes as credibility rises.

Also published as:

Journal of Macroeconomics (0164-0704)
September 2003. Vol. 25, Iss. 3, pp. 311-30