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Monetary Policy and Heterogeneous Expectations

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  • William A. Branch
  • George W. Evans

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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Paper provided by Centre for Dynamic Macroeconomic Analysis in its series CDMA Working Paper Series with number 201011.

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Date of creation: 15 Apr 2010
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Handle: RePEc:san:cdmawp:1011

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Keywords: Heterogeneous expectations; monetary policy; multiple equilib?ria; adaptive learning.;

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  1. Kaushik Mitra & James Bullard, . "Learning About Monetary Policy Rules," Discussion Papers, Department of Economics, University of York 00/41, Department of Economics, University of York.
  2. George Evans & William Branch, 2003. "Intrinsic Heterogeneity in Expectation Formation," Computing in Economics and Finance 2003 312, Society for Computational Economics.
  3. William Branch & Bruce McGough, 2011. "Business cycle amplification with heterogeneous expectations," Economic Theory, Springer, Springer, vol. 47(2), pages 395-421, June.
  4. George W. Evans & William A. Branch, 2005. "Model Uncertainty and Endogenous Volatility," Computing in Economics and Finance 2005, Society for Computational Economics 33, Society for Computational Economics.
  5. 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..
  6. Volker Wieland & Maik Wolters, 2011. "The diversity of forecasts from macroeconomic models of the US economy," Economic Theory, Springer, Springer, vol. 47(2), pages 247-292, June.
  7. Mark Gertler & Jordi Gali & Richard Clarida, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December.
  8. Mordecai Kurz & Maurizio Motolese, 2011. "Diverse beliefs and time variability of risk premia," Economic Theory, Springer, Springer, vol. 47(2), pages 293-335, June.
  9. McCallum, Bennett T., 1999. "Issues in the design of monetary policy rules," Handbook of Macroeconomics, Elsevier, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 23, pages 1483-1530 Elsevier.
  10. 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).
  11. Ernst Fehr & Jean-Robert Tyran, 2008. "Limited Rationality and Strategic Interaction: The Impact of the Strategic Environment on Nominal Inertia," Econometrica, Econometric Society, Econometric Society, vol. 76(2), pages 353-394, 03.
  12. Thomas J Sargent, 2007. "Evolution and Intelligent Design," Levine's Bibliography 122247000000001821, UCLA Department of Economics.
  13. William A. Branch, 2004. "The Theory of Rationally Heterogeneous Expectations: Evidence from Survey Data on Inflation Expectations," Economic Journal, Royal Economic Society, Royal Economic Society, vol. 114(497), pages 592-621, 07.
  14. Brock, W.A. & Hommes, C.H., 1996. "A Rational Route to Randomness," Working papers, Wisconsin Madison - Social Systems 9530r, Wisconsin Madison - Social Systems.
  15. Kurz, Mordecai, 1994. "On the Structure and Diversity of Rational Beliefs," Economic Theory, Springer, Springer, vol. 4(6), pages 877-900, October.
  16. George W. Evans & Seppo Honkapohja, 2003. "Expectations and the Stability Problem for Optimal Monetary Policies," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 70(4), pages 807-824, October.
  17. Wiliam Branch & George W. Evans, . "Asset Return Dynamics and Learning," University of Oregon Economics Department Working Papers, University of Oregon Economics Department 2006-14, University of Oregon Economics Department.
  18. Young, H. Peyton, 2004. "Strategic Learning and its Limits," OUP Catalogue, Oxford University Press, Oxford University Press, number 9780199269181, October.
  19. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, Elsevier, vol. 39(1), pages 195-214, December.
  20. Branch, William A. & McGough, Bruce, 2009. "A New Keynesian model with heterogeneous expectations," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 33(5), pages 1036-1051, May.
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Citations

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Cited by:
  1. Vicente da Gama Machado, 2012. "Monetary Policy, Asset Prices and Adaptive Learning," Working Papers Series, Central Bank of Brazil, Research Department 274, Central Bank of Brazil, Research Department.
  2. Mordecai Kurz, 2011. "Symposium: on the role of market belief in economic dynamics, an introduction," Economic Theory, Springer, Springer, vol. 47(2), pages 189-204, June.
  3. Paul De Grauwe, 2010. "Top-Down versus Bottom-Up Macroeconomics," CESifo Working Paper Series 3020, CESifo Group Munich.
  4. Carsten Nielsen, 2011. "Price stabilizing, Pareto improving policies," Economic Theory, Springer, Springer, vol. 47(2), pages 459-500, June.
  5. Volker Wieland & Maik Wolters, 2011. "The diversity of forecasts from macroeconomic models of the US economy," Economic Theory, Springer, Springer, vol. 47(2), pages 247-292, June.
  6. Orlando Gomes, 2010. "Nonlinear Inflation Expectations and Endogenous Fluctuations," Czech Economic Review, Charles University Prague, Faculty of Social Sciences, Institute of Economic Studies, Charles University Prague, Faculty of Social Sciences, Institute of Economic Studies, vol. 4(3), pages 263-280, November.
  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, C.E.P.R. Discussion Papers 8804, C.E.P.R. Discussion Papers.
  8. William Branch & Bruce McGough, 2011. "Business cycle amplification with heterogeneous expectations," Economic Theory, Springer, Springer, vol. 47(2), pages 395-421, June.
  9. 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, Birkbeck, Department of Economics, Mathematics & Statistics 1208, Birkbeck, Department of Economics, Mathematics & Statistics.
  10. Machado, Vicente da Gama, 2013. "Monetary policy rules, asset prices and adaptive learning," Journal of Financial Stability, Elsevier, Elsevier, vol. 9(3), pages 251-258.
  11. Gomes, Orlando, 2006. "The dynamics of television advertising with boundedly rational consumers," MPRA Paper 2847, University Library of Munich, Germany.
  12. Joseph Haslag & William Brock, 2014. "On Understanding the Cyclical Behavior of the Price Level and Inflation," Working Papers, Department of Economics, University of Missouri 1404, Department of Economics, University of Missouri, revised 01 Jul 2014.
  13. Paul Grauwe, 2011. "Animal spirits and monetary policy," Economic Theory, Springer, Springer, vol. 47(2), pages 423-457, June.
  14. Man-Keung Tang & Xiangrong Yu, 2011. "Communication of Central Bank Thinking and Inflation Dynamics," IMF Working Papers 11/209, International Monetary Fund.
  15. Roger Guesnerie & Pedro Jara-Moroni, 2011. "Expectational coordination in simple economic contexts," Economic Theory, Springer, Springer, vol. 47(2), pages 205-246, June.

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