A continuous-time model of monetary policy and inflation: A stochastic differential game (Q4036932)

[For the entire collection see Zbl 0755.00017.] The paper formulates and studies a continuous-time stochastic model of monetary policy and inflation, that incorporates asymmetric information between the private sector and the monetary authority. There are two versions of this problem, where (i) the private sector is a passive player who simply forms conditional (rational) expectations of the current inflation rate, which constitutes the surprise component of the policy maker's (the monetary authority) objective function. The policy maker, on the other hand, strives to maximize the objective function by choosing a control policy which also affects the information carried to the passive player whose rational expectations in turn influence the performance of that policy; (ii) the private sector is also an active player, and the game is strategically symmetric, with the objective function of the private sector being the least squares error of his estimate of the current inflation rate. Version (i) above requires the set-up of Stackelberg equilibria, and leads to a stochastic control problem of the non-neutral type, whose solution involves active learning. Version (ii), on the other hand, is a dynamic stochastic Nash game. The discrete-time versions of these two models were discussed earlier by \textit{A. Cuckierman} and \textit{A. Meltzer} [``A theory of ambiguity, credibility and inflation under discretion and asymmetric information'', Econometrica 54, No. 5, 1009-1128 (1986)], the author [IEEE Trans. Autom. Control AC-33, No. 12, 1122-1129 (1988; Zbl 0678.93058)], and the author and \textit{M. Salmon} [J. Econ. Dyn. Control 14, No. 1, 97-116 (1990; Zbl 0716.90010)]. This paper solves the continuous-time problem, for both Stackelberg and Nash equilibria, and presents some numerical results to complement the theoretical study.