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Heterogenous Information About the Term Structure of Interest Rates, Least-Squares Learning and Optimal Interest Rate Rules

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  • Eijffinger, Sylvester C W
  • Schaling, Eric
  • Tesfaselassie, Mewael F.

Abstract

In this Paper we incorporate the term structure of interest rates in a standard inflation forecast targeting framework. Learning about the transmission process of monetary policy is introduced by having heterogeneous agents - i.e. the central bank and private agents - who have different information sets about the future sequence of short-term interest rates. We analyse inflation forecast targeting in two environments. One in which the central bank has perfect knowledge, in the sense that it understands and observes the process by which private sector interest rate expectations are generated, and one in which the central bank has imperfect knowledge and has to learn the private sector forecasting rule for short-term interest rates. In the case of imperfect knowledge, the central bank has to learn about private sector interest rate expectations, as the latter affect the impact of monetary policy through the expectations theory of the term structure of interest rates. Here following Evans and Honkapohja (2001), the learning scheme we investigate is that of least-squares learning (recursive OLS) using the Kalman filter. We find that optimal monetary policy under learning is a policy that separates estimation and control. Therefore, this model suggests that the practical relevance of the breakdown of the separation principle and the need for experimentation in policy may be limited.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 4279.

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Date of creation: Mar 2004
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Handle: RePEc:cpr:ceprdp:4279

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Keywords: kalman filter; learning; rational expectations; separation principle; term structure of interest rates;

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  1. Rudebusch, Glenn D. & Svensson, Lars E. O., 1999. "Eurosystem Monetary Targeting: Lessons from U.S. Data," Working Paper Series 92, Sveriges Riksbank (Central Bank of Sweden).
  2. Orphanides, Athanasios & Williams, John C., 2003. "Imperfect knowledge, inflation expectations, and monetary policy," CFS Working Paper Series 2003/40, Center for Financial Studies (CFS).
  3. Fuhrer, Jeffrey C & Moore, George R, 1995. "Monetary Policy Trade-offs and the Correlation between Nominal Interest Rates and Real Output," American Economic Review, American Economic Association, vol. 85(1), pages 219-39, March.
  4. Wieland, Volker, 1999. "Monetary policy, parameter uncertainty and optimal learning," ZEI Working Papers B 09-1999, ZEI - Center for European Integration Studies, University of Bonn.
  5. James Bullard & Eric Schaling, 2000. "New economy - new policy rules?," Working Papers 2000-019, Federal Reserve Bank of St. Louis.
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  8. Eijffinger, S.C.W. & Schaling, E. & Verhagen, W.H., 1998. "The Term Structure of Interest Rates and Inflation Forecast Targeting," Discussion Paper 1998-85, Tilburg University, Center for Economic Research.
  9. Eric Schaling, 2004. "Learning, inflation expectations and optimal monetary policy," Macroeconomics 0404035, EconWPA.
  10. James B. Bullard, 1991. "Learning, rational expectations and policy: a summary of recent research," Review, Federal Reserve Bank of St. Louis, issue Jan, pages 50-60.
  11. Eric Schaling, 1999. "The non-linear Phillips curve and inflation forecast targeting," Bank of England working papers 98, Bank of England.
  12. Kaushik Mitra, . "Desirability of Nominal GDP Targeting Under Adaptive Learning," Discussion Papers 00/60, Department of Economics, University of York.
  13. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  14. Beck, Gunter W. & Wieland, Volker, 2002. "Learning and control in a changing economic environment," Journal of Economic Dynamics and Control, Elsevier, vol. 26(9-10), pages 1359-1377, August.
  15. Kiefer, Nicholas M & Nyarko, Yaw, 1989. "Optimal Control of an Unknown Linear Process with Learning," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 30(3), pages 571-86, August.
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