"Foggy windshield" in a new Keynesian model of the "natural rate"

Abstract

Bernanke (2004) said that measurement errors create a “foggy windshield” on the way central bank sees the economy. Indeed, monetary policy when facing real time data is subject to measurement errors that introduces undesirable movements on the interest rate that initiates unnecessary fluctuations in both inflation and output gap (or unemployment). The current thesis is based on a dynamic stochastic model where we have assumed the existence of imperfect competition in product market, labor market insiders as well as predetermined nominal wage contracts. Under the assumption that monetary authorities follow an interest rate rule and with no measurement errors, there is a meaningful tradeoff between stabilizing inflation and unemployment faced by the central bank because the only way to achieve it is with unanticipated inflation or shocks that are not anticipated by insiders during the wage determination process. Thus, the central bank can choose to fight aggressively inflation(unemployment) with a cost of a relatively high unemployment(inflation). However, when positive(negative) measurement errors are introduced, the central bank tend to over(under) react to the respective deviation and set the interest rate higher (or lower) from the desired level. As a result, the central bank can no longer fight aggressively inflation and deviations of output from his natural rate. Furthermore, the central bank has no option than to react to deviations of inflation from the target sufficiently strong because a strong reaction is a sufficient condition for the stability of the inflationary process. Thus, measurement errors cannot be fully eliminated from monetary authorities but the impact of them can be minimized from an appropriately parametrized and conditional with the objectives of the bank, Taylor (or Wicksell) rule.