SIGNALLING IN A MODEL OF MONETARY POLICY WITH INCOMPLETE INFORMATION

Expectations about government policy have an important effect on private-sector behavior, and these expectations depend partly on public beliefs about government objectives. The resulting incentive and opportunity for the government to signal its objectives are examined in the context of the natural-rate model proposed by Barro and Gordon (1983). It is shown that signaling affects the time path of inflation and unemployment. The election of a dry (one more worried about inflation than unemployment) policymaker may result in a period of high unemployment, accompanied by unexpectedly low inflation, followed by a reduction in inflationary expectations. The presence of incomplete information has broadly desirable welfare consequences. It allows signaling behavior that otherwise would not occur. Various techniques are employed to reduce the multiplicity of equilibria. One type survives all the techniques, namely that in which a dry signals dryness by doing the minimum necessary to persuade the public of that dryness.