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Monetary Policy under Adaptive Learning

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  • Vitor Gaspar
  • Frank Smets

Abstract

The paper studies the conduct of monetary policy, in a simple new Keynesian model, with adaptive learning on the part of the private sector. A key feature is that even though we start out with a linear “structural†model, the system and hence policy responses inherit the non-linear feature of the updating equations for the estimated parameters. In the paper, we contrast two different monetary policy regimes. In the first the central bank follows a simple rule, which comes from the first order conditions, for optimal policy under discretion in the case of rational expectations. In the second, the central bank has full information about the structure of the economy, including the adaptive learning mechanism. It takes the expectations formation mechanism explicitly into account when deriving optimal policy. This framework allows an explicit discussion of the importance of keeping inflation expectations under control. We illustrate with an application to a regime change, where we assume that the incumbent policymaker did not take the learning into account and allowed the expectation formation process to become unhinged. However, before inflation expectations (and actual inflation) spirals out of control, we assume that a sophisticated central banker, who does take the effect of learning into account, takes charge and study how the economy adjusts after the regime change. Under our assumptions the transition is slow. We claim that some features of the transition match important stylised facts associated with the Volcker disinflation in the US. In the end the fully optimal policy delivers less inflation and output gap volatility. It does so by anchoring inflation expectations thereby contributing to the overall stability of the economy. To achieve this result optimal policy is conditional on the degree of perceived persistence. As perceived persistence increases so does inertia in the policy response in the face of inflation shocks. We compare the contrast between the two policy regimes in the paper with the difference between the rational expectations under discretion and commitment.

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Bibliographic Info

Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2005 with number 80.

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Date of creation: 11 Nov 2005
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Handle: RePEc:sce:scecf5:80

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Related research

Keywords: monetary policy; adaptive learning; regime change;

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References

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  1. 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.
  2. Milani, Fabio, 2007. "Expectations, learning and macroeconomic persistence," Journal of Monetary Economics, Elsevier, vol. 54(7), pages 2065-2082, October.
  3. Frank Smets & Raf Wouters, 2003. "An Estimated Dynamic Stochastic General Equilibrium Model of the Euro Area," Journal of the European Economic Association, MIT Press, vol. 1(5), pages 1123-1175, 09.
  4. Steinsson, Jon, 2003. "Optimal monetary policy in an economy with inflation persistence," Journal of Monetary Economics, Elsevier, vol. 50(7), pages 1425-1456, October.
  5. Lawrence J. Christiano & Martin Eichenbaum & Charles Evans, 2001. "Nominal rigidities and the dynamic effects of a shock to monetary policy," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  6. Dixit, Avinash K & Stiglitz, Joseph E, 1977. "Monopolistic Competition and Optimum Product Diversity," American Economic Review, American Economic Association, vol. 67(3), pages 297-308, June.
  7. Lars E.O. Svensson, 2002. "What Is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules," Working Papers 118, Princeton University, Department of Economics, Center for Economic Policy Studies..
  8. Gaspar, Vitor & Smets, Frank, 2002. "Monetary Policy, Price Stability and Output Gap Stabilization," International Finance, Wiley Blackwell, vol. 5(2), pages 193-211, Summer.
  9. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  10. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
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Cited by:
  1. Athanasios Orphanides & John C. Williams, 2006. "Inflation targeting under imperfect knowledge," Working Paper Series 2006-14, Federal Reserve Bank of San Francisco.
  2. Michael Woodford, 2005. "Robustly Optimal Monetary Policy with Near Rational Expectations," NBER Working Papers 11896, National Bureau of Economic Research, Inc.
  3. Vitor Gaspar & Frank Smets & David Vestin, 2006. "Adaptive Learning, Persistence, and Optimal Monetary Policy," Journal of the European Economic Association, MIT Press, vol. 4(2-3), pages 376-385, 04-05.

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