Asymmetric Information, Two-Way Learning, and the Fed Information Effect

How important is the information effect of monetary policy? We first show analytically that the reduced-form method of regressing forecast revisions on monetary policy surprises leads to a biased estimation, due to the correlation between monetary policy surprises and the unobserved shocks. We then develop a New Keynesian model in which asymmetric information originates from a two-way learning mechanism: the central bank learns from lagged aggregate inflation and output, and firms learn from individual marginal costs and the interest rate. We calibrate our model parameters to match macroeconomic dynamics in the US and the forecast accuracy of the Federal Reserve and professional forecasters. Our calibrated model shows that the information effect reduces the output gaps caused by demand shocks and noise shocks, but may lead to a temporary rise in inflation after a contractionary monetary policy shock.