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The role of expectations in economic fluctuations and the efficacy of monetary policy

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  • Kurz, Mordecai
  • Jin, Hehui
  • Motolese, Maurizio

Abstract

We show diverse beliefs is an important propagation mechanism of fluctuations, money non neutrality and efficacy of monetary policy. Since expectations affect demand, our theory shows economic fluctuations are mostly driven by varying demand not supply shocks. Using a competitive model with flexible prices in which agents hold Rational Belief (see Kurz (1994)) we show that (i) our economy replicates well the empirical record of fluctuations in the U.S. (ii) Under monetary rules without discretion, monetary policy has a strong stabilization effect and an aggressive anti-inflationary policy can reduce inflation volatility to zero. (iii) The statistical Phillips Curve changes substantially with policy instruments and activist policy rules render it vertical. (iv) Although prices are flexible, money shocks result in less than proportional changes in inflation hence the aggregate price level appears “sticky” with respect to money shocks. (v) Discretion in monetary policy adds a random element to policy and increases volatility. The impact of discretion on the efficacy of policy depends upon the structure of market beliefs about future discretionary decisions. We study two rationalizable beliefs. In one case, market beliefs weaken the effect of policy and in the second, beliefs bolster policy outcomes and discretion could be a desirable attribute of the policy rule. Since the central bank does not know any more than the private sector, real social gain from discretion arise only in extraordinary cases. Hence, the weight of the argument leads us to conclude that bank’s policy should be transparent and abandon discretion except for rare and unusual circumstances. (vi) An implication of our model suggests the current effective policy is only mildly activist and aims mostly to target inflation. --

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

Volume (Year): 29 (2005)
Issue (Month): 11 (November)
Pages: 2017-2065

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Handle: RePEc:eee:dyncon:v:29:y:2005:i:11:p:2017-2065

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Citations

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Cited by:
  1. Volker Wieland & Maik Wolters, 2011. "The diversity of forecasts from macroeconomic models of the US economy," Economic Theory, Springer, vol. 47(2), pages 247-292, June.
  2. Mordecai Kurz, 2011. "Symposium: on the role of market belief in economic dynamics, an introduction," Economic Theory, Springer, vol. 47(2), pages 189-204, June.
  3. Mordecai Kurz & Maurizio Motolese, 2007. "Diverse Beliefs and Time Variability of Risk Premia," Discussion Papers 06-044, Stanford Institute for Economic Policy Research.
  4. Francesco Caprioli & Pietro Rizza & Pietro Tommasino, 2011. "Optimal Fiscal Policy when Agents Fear Government Default," Revue économique, Presses de Sciences-Po, vol. 62(6), pages 1031-1043.
  5. Hiroyuki Nakata, 2007. "A Model of Financial Markets with Endogenously Correlated Rational Beliefs," Economic Theory, Springer, vol. 30(3), pages 431-452, March.
  6. Branch, William A. & Evans, George W., 2010. "Monetary Policy and Heterogeneous Expectations," SIRE Discussion Papers 2010-32, Scottish Institute for Research in Economics (SIRE).
  7. Mordecai Kurz, 2005. "Measuring the Ex-Ante Social Cost of Aggregate Volatility," Discussion Papers 04-006, Stanford Institute for Economic Policy Research.
  8. Schmidt, Sebastian & Wieland, Volker, 2013. "The New Keynesian Approach to Dynamic General Equilibrium Modeling: Models, Methods and Macroeconomic Policy Evaluation," Handbook of Computable General Equilibrium Modeling, Elsevier.
  9. Kurz, Mordecai & Piccillo, Giulia & Wu, Howei, 2013. "Modeling diverse expectations in an aggregated New Keynesian Model," Journal of Economic Dynamics and Control, Elsevier, vol. 37(8), pages 1403-1433.
  10. Hiroyuki Nakata, 2013. "Welfare effects of short-sale constraints under heterogeneous beliefs," Economic Theory, Springer, vol. 53(2), pages 283-314, June.
  11. Marco Celentani & J. Ignacio Conde-Ruiz & Klaus Desmet, . "Inflation in open economies with complete markets," Working Papers 2004-12, FEDEA.
  12. William Branch & Bruce McGough, 2011. "Business cycle amplification with heterogeneous expectations," Economic Theory, Springer, vol. 47(2), pages 395-421, June.
  13. Mordecai Kurz, 2007. "Rational Diverse Beliefs and Economic Volatility," Discussion Papers 06-045, Stanford Institute for Economic Policy Research.
  14. Kurz, Mordecai, 2008. "Beauty contests under private information and diverse beliefs: How different?," Journal of Mathematical Economics, Elsevier, vol. 44(7-8), pages 762-784, July.
  15. Kyrtsou, Catherine & Malliaris, Anastasios G., 2009. "The impact of information signals on market prices when agents have non-linear trading rules," Economic Modelling, Elsevier, vol. 26(1), pages 167-176, January.

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