Welfare costs of monetary policy uncertainty in the economy with shifting trend inflation

Abstract

We study welfare costs of the uncertainty about monetary policy in the economy featuring shifting trend inflation. We follow Ruge-Murcia (J Econ Dyn Control 36: 914-938, 2012) to employ the SMM approach to fit the model to the US data (1979Q1-2015Q1). We find that the monetary policy uncertainty affects economic welfare through different dimensions. On the one hand, the policy uncertainty itself distorts the economic welfare negligibly, not only by increasing volatilities of consumption and leisure, but also by decreasing their average levels. A higher level of trend inflation then signifies these changes to produce greater welfare costs. Furthermore, the adverse impacts of policy uncertainty on the economy, documented by the impulse response functions of macroeconomic variables to policy uncertainty shock, become larger when central banks raise their inflation targets. On the other hand, the costs of exogenous variations in trend inflation are larger if there is policy uncertainty.

Effects of trend inflation on monetary policy and fiscal policy shocks in Vietnam

“…Ascari and Sbordone (2014) demonstrate that responses of the macroeconomy to monetary policy shocks are affected by trend inflation since it reduces the slope of the New Keynesian Phillip curve. Similar evidence on effects of trend inflation on the marginal efficiency of investment (MEI) shocks or monetary policy uncertainty shocks are also provided by Ascari et al (2018) and Ha et al (2020b), respectively. Second, Ascari and Sbordone (2014) and Ha et al (2020a) provide empirical evidence that changes in trend inflation are associated with the ability of the monetary authority to guarantee a determinacy region and macroeconomic stability.…”

“…They reveal that the welfare consequences of trend inflation are severe. Instead of directly measuring welfare costs of trend inflation, Ha et al (2020b) show that welfare costs of policy risk are signified if there is an increase in trend inflation. They also discuss mechanisms through which trend inflation indirectly affects economic welfare.…”

“…First, very few papers have examined effects of trend inflation on the consequences of policy shocks. Ascari and Sbordone (2014) pay attention to this issue, but they only consider the alternations of the transmission mechanism of monetary policy, while Ha et al (2020b) focus on monetary policy uncertainty. Prior scholars have not analyzed an interaction between trend inflation and fiscal policies.…”

“…Moreover, Kiley (2007), Ascari and Ropele (2009) and Coibion and Gorodnichenko (2011) have examined the relationship between trend inflation and the model's determinacy. Welfare analysis of trend inflation has also attracted the attention of many scholars such as Nakata (2014), Ascari et al (2018) and Ha et al (2019, 2020a, b). These studies have emphasized the importance and necessity of research on trend inflation.…”

“…In this paper, we follow Woodford (2003) to prove that the determinacy region that is derived from the Taylor principle when the central banks adopt the money supply rule narrow when trend inflation is higher [1]. Third, the literature has also provided empirical evidence that trend inflation influences welfare costs of shocks (Nakata, 2014; Ha et al ., 2019, 2020a) and volatility shocks (Ha et al , 2020b). However, the previous scholars have not paid enough attention to the effects of trend inflation on welfare costs of policy shocks.…”