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Adaptive learning, persistence, and optimal monetary policy

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  • Gaspar, Vítor
  • Smets, Frank
  • Vestin, David

Abstract

We show that, when private sector expectations are determined in line with adaptive learning, optimal policy responds persistently to cost-push shocks. The optimal response is stronger and more persistent, the higher is the initial level of perceived inflation persistence by the private sector. Such a sophisticated policy reduces inflation persistence and inflation volatility at little cost in terms of output gap volatility. Persistent responses to cost-push shocks and stability of inflation expectations resemble optimal policy under commitment and rational expectations. Nevertheless, it is clear that the mechanism at play is very different. In the case of commitment it relies on expectations of future policy actions affecting inflation expectations; in the case of sophisticated central banking it relies on the reduction in the estimated inflation persistence parameter based on inflation data generated by shocks and policy responses. JEL Classification: E52

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Paper provided by European Central Bank in its series Working Paper Series with number 0644.

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Date of creation: Jun 2006
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Handle: RePEc:ecb:ecbwps:20060644

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Keywords: Adaptive learning; optimal policy; policy rules; Rational Expectations;

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  1. 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.
  2. Richard Clarida & Jordi Galí & Mark Gertler, 1997. "The science of monetary policy: A new Keynesian perspective," Economics Working Papers 356, Department of Economics and Business, Universitat Pompeu Fabra, revised Apr 1999.
  3. Vitor Gaspar & Frank Smets, 2005. "Monetary Policy under Adaptive Learning," Computing in Economics and Finance 2005 80, Society for Computational Economics.
  4. Frank Smets & Raf Wouters, 2002. "An estimated dynamic stochastic general equilibrium model of the euro area," Working Paper Research 35, National Bank of Belgium.
  5. Vitor Gaspar & Frank Smets & David Vestin, 2006. "Optimal Monetary Policy under Adaptive Learning," Computing in Economics and Finance 2006 183, Society for Computational Economics.
  6. Lars E. O. Svensson, 2003. "What is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules," NBER Working Papers 9421, National Bureau of Economic Research, Inc.
  7. Fabio Milani, 2005. "Expectations, Learning and Macroeconomic Persistence," Macroeconomics 0510022, EconWPA.
  8. Athanasios Orphanides & John C. Williams, 2005. "Monetary policy with imperfect knowledge," Finance and Economics Discussion Series 2005-51, Board of Governors of the Federal Reserve System (U.S.).
  9. Gaspar, Vitor & Smets, Frank, 2002. "Monetary Policy, Price Stability and Output Gap Stabilization," International Finance, Wiley Blackwell, vol. 5(2), pages 193-211, Summer.
  10. Smets, Frank, 2003. "Maintaining price stability: how long is the medium term?," Journal of Monetary Economics, Elsevier, vol. 50(6), pages 1293-1309, September.
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  1. Bernanke: Inflation Expectations and Inflation Forecasting
    by Mark Thoma in Economist's View on 2007-07-10 20:08:00
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