Learning and the Signaling Effect of Monetary Policy

A heterogeneous expectations model is provided, where private agents facing policy ignorance have to learn about the underlying fundamentals via a signal extraction problem. The model is estimated on a U.S. data set using Bayesian approach. The empirical results imply that the improvement in policy credibility during Volcker disinflation is crucial for explaining why the survey private inflation forecast error turned from persistently positive to persistently negative around 1980. The strong positive comovement between inflation expectation and policy signal is found to partially offset central bank's ability to affect the real rate, explaining why inflation were so persistently heightened with monetary contraction during Great Inflation