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Monetary Policy and Heterogeneous Expectations

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  • Branch, William A.
  • Evans, George W.

Abstract

This paper studies the implications for monetary policy of heterogeneous expectations in a New Keynesian model. The assumption of rational expectations is replaced with parsimonious forecasting models where agents select between predictors that are underparameterized. In a Misspecification Equilibrium agents only select the best-performing statistical models. We demonstrate that, even when monetary policy rules satisfy the Taylor principle by adjusting nominal interest rates more than one for one with inflation, there may exist equilibria with Intrinsic Heterogeneity. Under certain conditions, there may exist multiple misspecification equilibria. We show that these findings have important implications for business cycle dynamics and for the design of monetary policy.

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Bibliographic Info

Paper provided by Scottish Institute for Research in Economics (SIRE) in its series SIRE Discussion Papers with number 2010-32.

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Date of creation: 2010
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Handle: RePEc:edn:sirdps:164

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Keywords: Heterogeneous expectations; monetary policy; multiple equilibria; adaptive learning;

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References

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  1. Mordecai Kurz & Maurizio Motolese, 2007. "Diverse Beliefs and Time Variability of Risk Premia," Discussion Papers 06-044, Stanford Institute for Economic Policy Research.
  2. Branch, William A. & Evans, George W., 2006. "Intrinsic heterogeneity in expectation formation," Journal of Economic Theory, Elsevier, vol. 127(1), pages 264-295, March.
  3. 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.
  4. repec:att:wimass:9530 is not listed on IDEAS
  5. Honkapohja, Seppo & Evans, George W., 2000. "Expectations and the stability problem for optimal monetary policies," Discussion Paper Series 1: Economic Studies 2000,10, Deutsche Bundesbank, Research Centre.
  6. Brock, W.A. & Hommes, C.H., 1996. "A Rational Route to Randomness," Working papers 9530r, Wisconsin Madison - Social Systems.
  7. Christopher A. Sims & Tao Zha, 2005. "Were There Regime Switches in U.S. Monetary Policy?," Working Papers 92, Princeton University, Department of Economics, Center for Economic Policy Studies..
  8. Ernst Fehr & Jean-Robert Tyran, . "Limited Rationality and Strategic Interaction, The Impact of the Strategic Environment on Nominal Inertia," IEW - Working Papers 130, Institute for Empirical Research in Economics - University of Zurich.
  9. William A. Branch, 2004. "The Theory of Rationally Heterogeneous Expectations: Evidence from Survey Data on Inflation Expectations," Economic Journal, Royal Economic Society, vol. 114(497), pages 592-621, 07.
  10. 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.
  11. William Branch & George W. Evans, 2007. "Model Uncertainty and Endogenous Volatility," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 10(2), pages 207-237, April.
  12. Wiliam Branch & George W. Evans, . "Asset Return Dynamics and Learning," University of Oregon Economics Department Working Papers 2006-14, University of Oregon Economics Department.
  13. Branch, William A. & McGough, Bruce, 2009. "A New Keynesian model with heterogeneous expectations," Journal of Economic Dynamics and Control, Elsevier, vol. 33(5), pages 1036-1051, May.
  14. Young, H. Peyton, 2004. "Strategic Learning and its Limits," OUP Catalogue, Oxford University Press, number 9780199269181.
  15. Kurz, Mordecai & Jin, Hehui & Motolese, Maurizio, 2005. "The role of expectations in economic fluctuations and the efficacy of monetary policy," Journal of Economic Dynamics and Control, Elsevier, vol. 29(11), pages 2017-2065, November.
  16. McCallum, Bennett T., 1999. "Issues in the design of monetary policy rules," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 23, pages 1483-1530 Elsevier.
  17. James Bullard & Kaushik Mitra, 2002. "Learning about monetary policy rules," Working Papers 2000-001, Federal Reserve Bank of St. Louis.
  18. Wieland, Volker & Wolters, Maik H., 2010. "The diversity of forecasts from macroeconomic models of the U.S. economy," CFS Working Paper Series 2010/08, Center for Financial Studies (CFS).
  19. Kurz, Mordecai, 1994. "On the Structure and Diversity of Rational Beliefs," Economic Theory, Springer, vol. 4(6), pages 877-900, October.
  20. William Branch & Bruce McGough, 2011. "Business cycle amplification with heterogeneous expectations," Economic Theory, Springer, vol. 47(2), pages 395-421, June.
  21. Thomas J Sargent, 2007. "Evolution and Intelligent Design," Levine's Bibliography 122247000000001821, UCLA Department of Economics.
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Citations

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Cited by:
  1. Paul Grauwe, 2011. "Animal spirits and monetary policy," Economic Theory, Springer, vol. 47(2), pages 423-457, June.
  2. Roger Guesnerie & Pedro Jara-Moroni, 2011. "Expectational coordination in simple economic contexts," Economic Theory, Springer, vol. 47(2), pages 205-246, June.
  3. Machado, Vicente da Gama, 2013. "Monetary policy rules, asset prices and adaptive learning," Journal of Financial Stability, Elsevier, vol. 9(3), pages 251-258.
  4. 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.
  5. Wieland, Volker & Wolters, Maik H, 2010. "The Diversity of Forecasts from Macroeconomic Models of the U.S. Economy," CEPR Discussion Papers 7870, C.E.P.R. Discussion Papers.
  6. Gomes, Orlando, 2006. "The dynamics of television advertising with boundedly rational consumers," MPRA Paper 2847, University Library of Munich, Germany.
  7. William Branch & Bruce McGough, 2011. "Business cycle amplification with heterogeneous expectations," Economic Theory, Springer, vol. 47(2), pages 395-421, June.
  8. Man-Keung Tang & Xiangrong Yu, 2011. "Communication of Central Bank Thinking and Inflation Dynamics," IMF Working Papers 11/209, International Monetary Fund.
  9. John Knight & Stephen Satchell & Nandini Srivastava, 2012. "Steady-State Distributions for Models of Bubbles: their Existence and Econometric Implications," Birkbeck Working Papers in Economics and Finance 1208, Birkbeck, Department of Economics, Mathematics & Statistics.
  10. Carsten Nielsen, 2011. "Price stabilizing, Pareto improving policies," Economic Theory, Springer, vol. 47(2), pages 459-500, June.
  11. Bofinger, Peter & Debes, Sebastian & Gareis, Johannes & Mayer, Eric, 2012. "Monetary Policy Transmission in a Model with Animal Spirits and House Price Booms and Busts," CEPR Discussion Papers 8804, C.E.P.R. Discussion Papers.
  12. Paul De Grauwe, 2010. "Top-Down versus Bottom-Up Macroeconomics," CESifo Working Paper Series 3020, CESifo Group Munich.
  13. Gomes, Orlando, 2006. "Nonlinear inflation expectations and endogenous fluctuations," MPRA Paper 2842, University Library of Munich, Germany.
  14. Vicente da Gama Machado, 2012. "Monetary Policy, Asset Prices and Adaptive Learning," Working Papers Series 274, Central Bank of Brazil, Research Department.
  15. Joseph Haslag & William Brock, 2014. "On Understanding the Cyclical Behavior of the Price Level and Inflation," Working Papers 1404, Department of Economics, University of Missouri, revised 01 Jul 2014.

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