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Heterogeneous information about the term structure, least-squares learning and optimal rules for inflation targeting

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Author Info

  • Schaling , Eric

    ()
    (Department of Economics, RAU and CentER for Economic Research, Tilburg University)

  • Eijffinger , Sylvester

    ()
    (CentER for Economic Research, Tilburg University and CEPR)

  • Tesfaselassie , Mewael

    (Tilburg University)

Abstract

In this paper we incorporate the term structure of interest rates into a standard inflation forecast targeting framework. Learning about the transmission process of monetary policy is introduced by having heterogeneous agents – ie 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. 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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File URL: http://www.suomenpankki.fi/en/julkaisut/tutkimukset/keskustelualoitteet/Documents/0423.pdf
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Bibliographic Info

Paper provided by Bank of Finland in its series Research Discussion Papers with number 23/2004.

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Length: 53 pages
Date of creation: 13 Oct 2004
Date of revision:
Handle: RePEc:hhs:bofrdp:2004_023

Contact details of provider:
Postal: Bank of Finland, P.O. Box 160, FI-00101 Helsinki, Finland
Web page: http://www.suomenpankki.fi/en/
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Related research

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

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References

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  1. Orphanides, Athanasios & Williams, John C., 2003. "Imperfect knowledge, inflation expectations, and monetary policy," CFS Working Paper Series 2003/40, Center for Financial Studies (CFS).
  2. 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.
  3. Wieland, Volker, 2000. "Monetary policy, parameter uncertainty and optimal learning," Journal of Monetary Economics, Elsevier, vol. 46(1), pages 199-228, August.
  4. Glenn D. Rudebusch & Lars E.O. Svensson, 1999. "Eurosystem Monetary Targeting: Lessons from U.S. Data," NBER Working Papers 7179, National Bureau of Economic Research, Inc.
  5. 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.
  6. Eric Schaling, 1999. "The non-linear Phillips curve and inflation forecast targeting," Bank of England working papers 98, Bank of England.
  7. Kaushik Mitra, . "Desirability of Nominal GDP Targeting Under Adaptive Learning," Discussion Papers 00/60, Department of Economics, University of York.
  8. Schaling, Eric, 2003. "Learning, inflation expectations and optimal monetary policy," Research Discussion Papers 20/2003, Bank of Finland.
  9. James B. Bullard & Eric Schaling, 2001. "New economy-new policy rules," Review, Federal Reserve Bank of St. Louis, issue May, pages 57-66.
  10. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," CEPR Discussion Papers 2139, C.E.P.R. Discussion Papers.
  11. Jovanovic, B. & Nyarko, Y., 1996. "Learning by Doing and the Choice of Technology," Working Papers 96-25, C.V. Starr Center for Applied Economics, New York University.
  12. 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.
  13. Foster, Andrew D & Rosenzweig, Mark R, 1995. "Learning by Doing and Learning from Others: Human Capital and Technical Change in Agriculture," Journal of Political Economy, University of Chicago Press, vol. 103(6), pages 1176-1209, December.
  14. 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.
  15. 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.
  16. 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.
  17. Klok, H.J. & Schaik, A.B.T.M. van & Smulders, J.A., 2001. "Economologues: Liber Amicorum voor Theo van de Klundert," Open Access publications from Tilburg University urn:nbn:nl:ui:12-86472, Tilburg University.
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Citations

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Cited by:
  1. Mikko Puhakka, 2005. "Equilibrium dynamics under lump-sum taxation in an exchange economy with skewed endowments," Macroeconomics 0508033, EconWPA.
  2. Leitemo, Kai & Söderström, Ulf, 2004. "Robust Monetary Policy in the New-Keynesian Framework," CEPR Discussion Papers 4805, C.E.P.R. Discussion Papers.
  3. Tesfaselassie, M.F. & Schaling, E. & Eijffinger, S.C.W., 2006. "Learning about the Term Structure and Optimal Rules for Inflation Targeting," Discussion Paper 2006-88, Tilburg University, Center for Economic Research.
  4. Antti Suvanto & Juhana Hukkinen, 2005. "Stable price level and changing prices," Macroeconomics 0508034, EconWPA.

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