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Learning, expectations formation and the pitfalls of optimal control monetary policy

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  • Athanasios Orphanides
  • John C. Williams

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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Paper provided by Federal Reserve Bank of San Francisco in its series Working Paper Series with number 2008-05.

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Date of creation: 2008
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Handle: RePEc:fip:fedfwp:2008-05

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Keywords: Rational expectations (Economic theory) ; Econometric models;

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Citations

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Cited by:
  1. Mayer, Eric & Scharler, Johann, 2011. "Noisy information, interest rate shocks and the Great Moderation," Journal of Macroeconomics, Elsevier, Elsevier, vol. 33(4), pages 568-581.
  2. 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.
  3. Roberto Tamborini, 2010. "Monetary Policy With Investment-Saving Imbalances," Metroeconomica, Wiley Blackwell, Wiley Blackwell, vol. 61(3), pages 473-509, 07.
  4. Tsvetomira Tsenova, 2013. "International Monetary Transmission with Bank Heterogeneity and Default Risk," FIW Working Paper series, FIW 110, FIW.
  5. Orphanides, Athanasios, 2010. "Monetary Policy Lessons from the Crisis," CEPR Discussion Papers, C.E.P.R. Discussion Papers 7891, C.E.P.R. Discussion Papers.
  6. 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.
  7. Paul Hubert, 2013. "ECB projections as a tool for understanding policy decisions," Documents de Travail de l'OFCE, Observatoire Francais des Conjonctures Economiques (OFCE) 2013-04, Observatoire Francais des Conjonctures Economiques (OFCE).
  8. Paul Hubert, 2013. "ECB projections as a tool for understanding policy decisions," Documents de Travail de l'OFCE, Observatoire Francais des Conjonctures Economiques (OFCE) 2013-04, Observatoire Francais des Conjonctures Economiques (OFCE).

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