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Imperfect Knowledge, Adaptive Learning, and the Bias Against Activist Monetary Policies

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  • Alberto Locarno

    (Research Department, Banca d'Italia and London School of Economics)

Abstract

The paper studies the implications for the effectiveness of discretionary monetary policymaking of departing from the assumption of rational expectations. Society, whose welfare function is quadratic, can appoint a central banker whose preferences are either quadratic or lexicographic, to achieve the best mix of inflation and output stability. The focus on lexicographic preferences is justified on the grounds that they imply a strict ordering of policy objectives, which is typical of the mandate of several central banks. Both the private sector and the monetary policymaker have incomplete knowledge of the working of the economy and rely upon adaptive learning to form expectations and decide policy moves. The model economy is assumed to be subject to recurrent unobserved shifts, and the monetary authority, who has private information on the shocks hitting the economy, cannot credibly commit. The main finding of the paper is that when agents rely on an adaptive learning technology, a bias against activist policies arises. The paper also shows that when society has quadratic utility, a strategy based on a strict ordering of objectives is close to optimal for a wide range of values of the inflation aversion parameter.

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Bibliographic Info

Article provided by International Journal of Central Banking in its journal International Journal of Central Banking.

Volume (Year): 3 (2007)
Issue (Month): 3 (September)
Pages: 47-85

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Handle: RePEc:ijc:ijcjou:y:2007:q:3:a:2

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  1. Giuseppe Ferrero, 2004. "Monetary policy and the transition to rational expectations," Computing in Economics and Finance 2004 19, Society for Computational Economics.
  2. Gaspar,Vítor & Issing,Otmar & Tristani,Oreste & Vestin,David, 2006. "Imperfect Knowledge and Monetary Policy," Cambridge Books, Cambridge University Press, number 9780521854863, December.
  3. Ellison, Martin & Valla, Natacha, 2001. "Learning, uncertainty and central bank activism in an economy with strategic interactions," Journal of Monetary Economics, Elsevier, vol. 48(1), pages 153-171, August.
  4. repec:fip:fedfap:2002-04 is not listed on IDEAS
  5. Albert Marcet & Thomas J. Sargent, 1992. "Speed of convergence of recursive least squares learning with ARMA perceptions," Economics Working Papers 15, Department of Economics and Business, Universitat Pompeu Fabra.
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  7. Athanasios Orphanides & John Williams, 2004. "Imperfect Knowledge, Inflation Expectations, and Monetary Policy," NBER Chapters, in: The Inflation-Targeting Debate, pages 201-246 National Bureau of Economic Research, Inc.
  8. Honkapohja, S. & Evans, G.W., 2000. "Expectations and the Stability Problem for Optimal Monetary Policies," University of Helsinki, Department of Economics 481, Department of Economics.
  9. Athanasios Orphanides & David W. Wilcox, 1996. "The opportunistic approach to disinflation," Finance and Economics Discussion Series 96-24, Board of Governors of the Federal Reserve System (U.S.).
  10. Bertocchi, Graziella & Spagat, Michael, 1993. "Learning, experimentation, and monetary policy," Journal of Monetary Economics, Elsevier, vol. 32(1), pages 169-183, August.
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  16. Svensson, Lars E. O. & Woodford, Michael, 2000. "Indicator variables for optimal policy," Working Paper Series 0012, European Central Bank.
  17. Balvers, Ronald J & Cosimano, Thomas F, 1994. "Inflation Variability and Gradualist Monetary Policy," Review of Economic Studies, Wiley Blackwell, vol. 61(4), pages 721-38, October.
  18. al-Nowaihi, Ali & Stracca, Livio, 2002. "Non-standard central bank loss functions, skewed risks, and certainty equivalence," Working Paper Series 0129, European Central Bank.
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