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Forward-looking Behaviour and Credibility: Some Evidence and Implications for Policy

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Author Info

  • Gordon de Brouwer

    (Reserve Bank of Australia)

  • Luci Ellis

    (Reserve Bank of Australia)

Abstract

Whether people form their expectations of the future in a model-consistent or extrapolative manner, has implications for the way the economy and monetary policy are modelled. The first half of this paper provides three pieces of information about inflation expectations – that survey measures of expectations are inconsistent with rational expectations, but less so for financial markets than households; that actual and expected inflation interact with each other; and that the foreign exchange market anticipates tighter monetary policy when inflation is higher than expected. The second half of the paper explores some policy implications. First, the variability of inflation and output is lower when policy-makers respond to model-based forecasts, rather than just current values, of inflation and output. Second, model-consistent behaviour elsewhere in the economy stabilises inflation and output, given that the model includes a central bank reaction function which the public believes the bank will adhere to. When inflation expectations differ between groups, the ex ante real interest rates that affect output and the exchange rate differ from each other, and this can induce oscillations or overshooting in the exchange rate, with consequences for the variability of inflation and output. Third, ‘optimal’ policy cannot fully compensate for the greater variability in inflation and output associated with extrapolative expectations.

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Bibliographic Info

Paper provided by Reserve Bank of Australia in its series RBA Research Discussion Papers with number rdp9803.

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Date of creation: Feb 1998
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Handle: RePEc:rba:rbardp:rdp9803

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Related research

Keywords: expectations; inflation; credibility; monetary policy;

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References

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  1. Cochrane, John H., 1998. "What do the VARs mean? Measuring the output effects of monetary policy," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 277-300, April.
  2. Gordon de Brouwer & Neil R. Ericsson, 1995. "Modelling Inflation in Australia," RBA Research Discussion Papers rdp9510, Reserve Bank of Australia.
  3. Ben S. Bernanke & Michael Woodford, 1997. "Inflation Forecasts and Monetary Policy," NBER Working Papers 6157, National Bureau of Economic Research, Inc.
  4. repec:nbr:nberre:0126 is not listed on IDEAS
  5. David Gruen & Geoffrey Shuetrim, 1994. "Internationalisation and the Macroeconomy," RBA Annual Conference Volume, in: Philip Lowe & Jacqueline Dwyer (ed.), International Intergration of the Australian Economy Reserve Bank of Australia.
  6. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  7. Guy Debelle & Glenn Stevens, 1995. "Monetary Policy Goals for Inflation in Australia," RBA Research Discussion Papers rdp9503, Reserve Bank of Australia.
  8. John M. Roberts, 1994. "Is inflation sticky?," Working Paper Series / Economic Activity Section 152, Board of Governors of the Federal Reserve System (U.S.).
  9. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
  10. Taylor, John B, 1980. "Aggregate Dynamics and Staggered Contracts," Journal of Political Economy, University of Chicago Press, vol. 88(1), pages 1-23, February.
  11. Blake, Andrew P & Westaway, Peter F, 1996. "Credibility and the Effectiveness of Inflation Targeting Regimes," The Manchester School of Economic & Social Studies, University of Manchester, vol. 64(0), pages 28-50, Suppl..
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Cited by:
  1. Levin, Andrew & Wieland, Volker & Williams, John C., 2003. "The performance of forecast-based monetary policy rules under model uncertainty," CFS Working Paper Series 2003/06, Center for Financial Studies (CFS).
  2. Kevin Lee & Nilss Olekalns & Kalvinder Shields, 2012. "Meta Taylor Rules for the UK and Australia; Accommodating Regime Uncertainty in Monetary Policy Analysis using Model Averaging Methods," Department of Economics - Working Papers Series 1138, The University of Melbourne.
  3. Kevin X.D. Huang & Qinglai Meng, 2007. "Is Forward-Looking Inflation Targeting Destabilizing? The Role of Policy's Response to Current Output under Endogenous Investment," Vanderbilt University Department of Economics Working Papers 0704, Vanderbilt University Department of Economics.
  4. Frank Campbell & Eleanor Lewis, 1998. "What Moves Yields in Australia?," RBA Research Discussion Papers rdp9808, Reserve Bank of Australia.
  5. Marcela Meirelles Aurelio, 2005. "Do we really know how inflation targeters set interest rates?," Research Working Paper RWP 05-02, Federal Reserve Bank of Kansas City.
  6. David Hargreaves, 1999. "SDS-FPS: a small demand-side version of the Forecasting and Policy System core model," Reserve Bank of New Zealand Discussion Paper Series G99/10, Reserve Bank of New Zealand.
  7. West, L.k. & Agbola, W.F., 2005. "Causality Links Between Asset Prices And Cash Rate In Australia," International Journal of Applied Econometrics and Quantitative Studies, Euro-American Association of Economic Development, vol. 2(3), pages 69-86.

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