Central bank’s two-way communication with the public and inflation dynamics

Using a model of island economy where financial markets aggregate dispersed informationof the public, we analyze how two-way communication between the central bankand the public affects inflation dynamics. When inflation target is observable and credibleto the public, markets provide the bank with information about the aggregate state ofthe economy, and hence the bank can stabilize inflation. However, when inflation targetis unobservable or less credible, the public updates their perceived inflation target and theinformation revealed from markets to the bank becomes less perfect. The degree of uncertaintyfacing the bank crucially depends on how two-way communication works.[...]