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Learning, Expectations Formation, and the Pitfalls of Optimal Control Monetary Policy

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  • Athanasios Orphanides

    ()
    (Central Bank of Cyprus)

  • John C. Williams

    ()
    (Federal Reserve Bank of San Francisco)

Abstract

This paper examines the robustness characteristics of optimal control policies derived under the assumption of rational expectations to alternative models of expectations. We assume that agents have imperfect knowledge about the precise structure of the economy and form expectations using a forecasting model that they continuously update based on incoming data. We find that the optimal control policy derived under the assumption of rational expectations can perform poorly when expectations deviate modestly from rational expectations. We then show that the optimal control policy can be made more robust by deemphasizing the stabilization of real economic activity and interest rates relative to inflation in the central bank loss function. That is, robustness to learning provides an incentive to employ a "conservative" central banker. We then examine two types of simple monetary policy rules from the literature that have been found to be robust to model misspecification in other contexts. We find that these policies are robust to empirically plausible parameterizations of the learning models and perform about as well or better than optimal control policies.

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File URL: http://www.centralbank.gov.cy/media/pdf/NPWPE_No3_04_2008_.pdf
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Bibliographic Info

Paper provided by Central Bank of Cyprus in its series Working Papers with number 2008-3.

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Length: 41 pages
Date of creation: Apr 2008
Date of revision:
Handle: RePEc:cyb:wpaper:2008-3

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Web page: http://www.centralbank.gov.cy/nqcontent.cfm?a_id=1
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Keywords: Rational expectations; robust control; model uncertainty;

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References

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  1. Athanasios Orphanides & John C. Williams, 2006. "Inflation targeting under imperfect knowledge," Finance and Economics Discussion Series 2006-20, Board of Governors of the Federal Reserve System (U.S.).
  2. 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.
  3. Andrew T. Levin & John C. Williams, 2003. "Robust monetary policy with competing reference models," Working Paper Series 2003-10, Federal Reserve Bank of San Francisco.
  4. Gaspar, Vítor & Smets, Frank & Vestin, David, 2006. "Adaptive learning, persistence, and optimal monetary policy," Working Paper Series 0644, European Central Bank.
  5. Orphanides, Athanasios & Williams, John C., 2003. "Imperfect knowledge, inflation expectations, and monetary policy," CFS Working Paper Series 2003/40, Center for Financial Studies (CFS).
  6. William Brock & Steven Durlauf & Kenneth West, 2005. "Model uncertainty and policy evaluation: some theory and empirics," Proceedings, Federal Reserve Bank of San Francisco.
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  8. Svensson, Lars O & Tetlow, Robert J, 2005. "Optimal Policy Projections," MPRA Paper 839, University Library of Munich, Germany.
  9. Lars Svensson & Noah Williams, 2005. "Monetary Policy with Model Uncertainty: Distribution Forecast Targeting," NBER Working Papers 11733, National Bureau of Economic Research, Inc.
  10. Athanasios Orphanides & John C. Williams, 2007. "Robust monetary policy with imperfect knowledge," Working Paper Series 2007-08, Federal Reserve Bank of San Francisco.
  11. Lars E.O. Svensson, 2002. "Inflation Targeting: Should It Be Modeled as an Instrument Rule or a Targeting Rule?," NBER Working Papers 8925, National Bureau of Economic Research, Inc.
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Citations

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Cited by:
  1. Paul Hubert, 2013. "ECB projections as a tool for understanding policy decisions," Documents de Travail de l'OFCE 2013-04, Observatoire Francais des Conjonctures Economiques (OFCE).
  2. Orphanides, Athanasios, 2010. "Monetary Policy Lessons from the Crisis," CEPR Discussion Papers 7891, C.E.P.R. Discussion Papers.
  3. Luisa Lambertini & Caterina Mendicino & Maria Teresa Punzi, 2011. "Leaning Against Boom-Bust Cycles in Credit and Housing Prices," Working Papers CELEG 1104, Dipartimento di Economia e Finanza, LUISS Guido Carli.
  4. Eric Mayer & Johann Scharler, 2010. "Noisy Information, Interest Rate Shocks and the Great Moderation," Economics working papers 2010-07, Department of Economics, Johannes Kepler University Linz, Austria.
  5. Piotr Banbula & Witold Kozinski & Michal Rubaszek, 2011. "The role of the exchange rate in monetary policy in Poland," BIS Papers chapters, in: Bank for International Settlements (ed.), Capital flows, commodity price movements and foreign exchange intervention, volume 57, pages 285-295 Bank for International Settlements.
  6. Paul Hubert, 2013. "ECB projections as a tool for understanding policy decisions," Documents de Travail de l'OFCE 2013-04, Observatoire Francais des Conjonctures Economiques (OFCE).

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