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Monetary Policy and Heterogeneous Expectations

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  • George W. Evans

    ()
    (University of Oregon Economics Department and University of St. Andrews)

  • William A.Branch

    ()
    (University of Califorina, Irvine)

Abstract

This paper studies the implications for monetary policy of heterogeneous expectations in a New Keynesian model. The assumption of rational expec- tations is replaced with parsimonious forecasting models where agents select between predictors that are underparameterized. In a Misspecification Equilib- rium 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 im- portant implications for business cycle dynamics and for the design of monetary policy.

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Bibliographic Info

Paper provided by University of Oregon Economics Department in its series University of Oregon Economics Department Working Papers with number 2010-4.

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Length: 35
Date of creation: 30 Apr 2010
Date of revision:
Handle: RePEc:ore:uoecwp:2010-4

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

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References

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  1. Kaushik Mitra & James Bullard, . "Learning About Monetary Policy Rules," Discussion Papers 00/41, Department of Economics, University of York.
  2. Kurz, Mordecai & Jin, Hehui & Motolese, Maurizio, 2003. "The role of expectations in economic fluctuations and the efficacy of monetary policy," CFS Working Paper Series 2003/42, Center for Financial Studies (CFS).
  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. 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.
  5. 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.
  6. Honkapohja, S. & Evans, G.W., 2000. "Expectations and the Stability Problem for Optimal Monetary Policies," University of Helsinki, Department of Economics 481, Department of Economics.
  7. 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.
  8. Brock, W.A. & Hommes, C.H., 1996. "A Rational Route to Randomness," Working papers 9530r, Wisconsin Madison - Social Systems.
  9. Young, H. Peyton, 2004. "Strategic Learning and its Limits," OUP Catalogue, Oxford University Press, number 9780199269181, October.
  10. Bennett T. McCallum, 1997. "Issues in the Design of Monetary Policy Rules," NBER Working Papers 6016, National Bureau of Economic Research, Inc.
  11. Branch, William A. & Evans, George W., 2006. "Intrinsic heterogeneity in expectation formation," Journal of Economic Theory, Elsevier, vol. 127(1), pages 264-295, March.
  12. Kurz, Mordecai, 1994. "On the Structure and Diversity of Rational Beliefs," Economic Theory, Springer, vol. 4(6), pages 877-900, October.
  13. 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.
  14. 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.
  15. William A. Branch & George W. Evans, 2010. "Asset Return Dynamics and Learning," Review of Financial Studies, Society for Financial Studies, vol. 23(4), pages 1651-1680, April.
  16. 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..
  17. Thomas J. Sargent, 2008. "Evolution and Intelligent Design," American Economic Review, American Economic Association, vol. 98(1), pages 5-37, March.
  18. 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.
  19. William Branch & Bruce McGough, 2011. "Business cycle amplification with heterogeneous expectations," Economic Theory, Springer, vol. 47(2), pages 395-421, June.
  20. Mordecai Kurz & Maurizio Motolese, 2007. "Diverse Beliefs and Time Variability of Risk Premia," Discussion Papers 06-044, Stanford Institute for Economic Policy Research.
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Citations

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Cited by:
  1. Machado, Vicente da Gama, 2013. "Monetary policy rules, asset prices and adaptive learning," Journal of Financial Stability, Elsevier, vol. 9(3), pages 251-258.
  2. 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).
  3. Carsten Nielsen, 2011. "Price stabilizing, Pareto improving policies," Economic Theory, Springer, vol. 47(2), pages 459-500, June.
  4. Paul Grauwe, 2011. "Animal spirits and monetary policy," Economic Theory, Springer, vol. 47(2), pages 423-457, June.
  5. 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.
  6. 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.
  7. 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.
  8. Paul De Grauwe, 2010. "Top-Down versus Bottom-Up Macroeconomics," CESifo Working Paper Series 3020, CESifo Group Munich.
  9. Vicente da Gama Machado, 2012. "Monetary Policy, Asset Prices and Adaptive Learning," Working Papers Series 274, Central Bank of Brazil, Research Department.
  10. William Branch & Bruce McGough, 2011. "Business cycle amplification with heterogeneous expectations," Economic Theory, Springer, vol. 47(2), pages 395-421, June.
  11. Orlando Gomes, 2010. "Nonlinear Inflation Expectations and Endogenous Fluctuations," Czech Economic Review, Charles University Prague, Faculty of Social Sciences, Institute of Economic Studies, vol. 4(3), pages 263-280, November.
  12. Gomes, Orlando, 2006. "The dynamics of television advertising with boundedly rational consumers," MPRA Paper 2847, University Library of Munich, Germany.
  13. Man-Keung Tang & Xiangrong Yu, 2011. "Communication of Central Bank Thinking and Inflation Dynamics," IMF Working Papers 11/209, International Monetary Fund.
  14. 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.
  15. Roger Guesnerie & Pedro Jara-Moroni, 2011. "Expectational coordination in simple economic contexts," Economic Theory, Springer, vol. 47(2), pages 205-246, June.

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