Forward-looking Behaviour and Credibility: Some Evidence and Implications for Policy
AbstractWhether 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 InfoPaper provided by Reserve Bank of Australia in its series RBA Research Discussion Papers with number rdp9803.
Date of creation: Feb 1998
Date of revision:
Find related papers by JEL classification:
- C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
- D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
- E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
- E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
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