‘Talking down monetary policy’ – a note

ABSTRACT

There is a recent debate about whether ultra-expansionary monetary policy is no longer effective in stimulating demand, a concern often voiced in the euro area in light of persistently low and even negative inflation. As a response, the European Central Bank (ECB) warns against ‘talking down monetary policy’ (ECB Vice-President Vítor Constâncio, 2016). This note uses a textbook model of optimal monetary policy to study a situation in which the public misperceives the interest rate elasticity of aggregate demand, which reflects policy effectiveness. We show that as a result of underestimating policy effectiveness demand shocks can no longer be stabilized perfectly, thus resulting in inefficient inflation and output dynamics. In the presence of misperceptions, a negative demand shock leads to a prolonged period of negative inflation rates.

KEYWORDS:

• Optimal monetary policy
• policy effectiveness
• shocks
• inflation
• misperception

JEL CLASSIFICATION:

• E31
• E32
• E58

Disclosure statement

No potential conflict of interest was reported by the author.

Notes

¹ For a textbook treatment, see Walsh (2010).

² Note that this article focuses on misperceptions on part of households. Romer and Romer (2013) study the ineffectiveness of policy as perceived by policymakers themselves.

³ This solution is independent of . This reflects the ‘divine coincidence’ that is characterizing the dynamics resulting from a demand shock.