Optimal Monetary Policy When Agents Are Learning
AbstractMost studies of optimal monetary policy under learning rely on optimality conditions derived for the case when agents have rational expectations. In this paper, we derive optimal monetary policy in an economy where the Central Bank knows, and makes active use of, the learning algorithm agents follow in forming their expectations. In this setup, monetary policy can influence future expectations through its effect on learning dynamics, introducing an additional trade-off between inflation and output gap stabilization. Specifically, the optimal interest rate rule reacts more aggressively to out of equilibrium inflation expectations and noisy cost-push shocks than would be optimal under rational expectations: the Central Bank exploits its ability to “drive” future inflation expectations closer to equilibrium. This optimal policy qualitatively resembles optimal policy when the Central Bank can commit and agents have rational expectations. Moreover, when beliefs are updated according to recursive least squares, the optimal policy is time-varying: after a structural break the Central Bank should be more aggressive and relax the degree of aggressiveness in subsequent periods. The policy recommendation is robust: under our policy the welfare loss if the private sector actually has rational expectations is much smaller than if the Central Bank mistakenly assumes rational expectations whereas in fact agents are learning.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by Society for Economic Dynamics in its series 2008 Meeting Papers with number 679.
Date of creation: 2008
Date of revision:
Contact details of provider:
Postal: Society for Economic Dynamics Christian Zimmermann Economic Research Federal Reserve Bank of St. Louis PO Box 442 St. Louis MO 63166-0442 USA
Web page: http://www.EconomicDynamics.org/society.htm
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Giuseppe Ferrero, 2004.
"Monetary policy and the transition to rational expectations,"
Computing in Economics and Finance 2004, Society for Computational Economics
19, Society for Computational Economics.
- Giuseppe Ferrero, 2004. "Monetary Policy and the Transition to Rational Expectations," Econometric Society 2004 North American Summer Meetings, Econometric Society 101, Econometric Society.
- Giuseppe Ferrero, 2004. "Monetary Policy and the Transition to Rational Expectations," Temi di discussione (Economic working papers), Bank of Italy, Economic Research and International Relations Area 499, Bank of Italy, Economic Research and International Relations Area.
- Adam, Klaus & Billi, Roberto M., 2007.
"Discretionary monetary policy and the zero lower bound on nominal interest rates,"
Journal of Monetary Economics, Elsevier,
Elsevier, vol. 54(3), pages 728-752, April.
- Adam, Klaus & Billi, Roberto M., 2005. "Discretionary monetary policy and the zero lower bound on nominal interest rates," CFS Working Paper Series, Center for Financial Studies (CFS) 2005/16, Center for Financial Studies (CFS).
- Klaus Adam & Roberto M. Billi, 2005. "Discretionary monetary policy and the zero lower bound on nominal interest rates," Research Working Paper, Federal Reserve Bank of Kansas City RWP 05-08, Federal Reserve Bank of Kansas City.
- Klaus Adam & Mario Padula, 2002.
"Inflation Dynamics and Subjective Expectations in the United States,"
CSEF Working Papers, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy
78, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy, revised 02 Jun 2009.
- Klaus Adam & Mario Padula, 2011. "Inflation Dynamics And Subjective Expectations In The United States," Economic Inquiry, Western Economic Association International, Western Economic Association International, vol. 49(1), pages 13-25, 01.
- Adam, Klaus & Padula, Mario, 2003. "Inflation dynamics and subjective expectations in the United States," Working Paper Series, European Central Bank 0222, European Central Bank.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Christian Zimmermann).
If references are entirely missing, you can add them using this form.