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Monetary Policy Design under Imperfect Knowledge: An Open Economy Analysis

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Author Info
Yu-chin Chen (University of Washington)
Pisut Kulthanavit (University of Washington)
Abstract

This paper incorporates adaptive learning into a standard New-Keynesian open economy dynamic stochastic general equilibrium (DSGE) model and analyze under what conditions policymakers should target domestic producer price inflation (DI) versus consumer price inflation (CI). Our goal is to examine how monetary policy rules should adjust when agents’ information sets deviate from those assumed under the rational expectation paradigm. When agents form expectations using an adaptive learning mechanism, even though the central bank has no informational advantage, monetary policy can nonetheless facilitate the learning process and thus mitigate distortions associated with imperfect knowledge. We assume the policy-maker follows a forwardlooking Taylor rule and focus on analyzing the interplay between the source of the dominant shock and the extent of knowledge imperfection. We find that when agents have very limited knowledge and have to learn the dynamics governing both the relevant economic indicators and the underlying structural shocks, a DI targeting rule introduces fewer forecast errors and is better at stabilizing the economy. However, when agents can observe contemporaneous shocks and need only learn how key economic variables evolve (a situation akin to a post-structural-shift economy), targeting away from the dominant shocks helps anchor expectations and improve welfare. A CI target can then become the preferred policy rule when the economy is subject to large domestic shocks.

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Paper provided by University of Washington, Department of Economics in its series Working Papers with number UWEC-2008-14.

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Date of creation: May 2008
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Handle: RePEc:udb:wpaper:uwec-2008-14

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  2. James B. Bullard & Eric Schaling, 2006. "Monetary policy, determinacy, and learnability in a two-block world economy," Working Papers 2006-038, Federal Reserve Bank of St. Louis. [Downloadable!]
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  4. Richard Clarida & Jordi Gali & Mark Gertler, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December. [Downloadable!] (restricted)
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  5. Athanasios Orphanides & John C. Williams, 2003. "Imperfect Knowledge, Inflation Expectations, and Monetary Policy," NBER Working Papers 9884, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  6. Alessia Campolmi, 2006. "Which inflation to target? A small open economy with sticky wages indexed to past inflation," Economics Working Papers 961, Department of Economics and Business, Universitat Pompeu Fabra. [Downloadable!]
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  7. Aoki, Kosuke, 2001. "Optimal monetary policy responses to relative-price changes," Journal of Monetary Economics, Elsevier, vol. 48(1), pages 55-80, August. [Downloadable!] (restricted)
  8. Gianluca Benigno & Pierpaolo Benigno, 2003. "Price Stability in Open Economies," Review of Economic Studies, Blackwell Publishing, vol. 70(4), pages 743-764, October. [Downloadable!] (restricted)
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  11. Bennett T. McCallum, 1983. "On Non-Uniqueness in Rational Expectations Models: An Attempt at Perspective," NBER Working Papers 0684, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  12. Warwick J. McKibbin & Kang Yong Tan, 2006. "Learning And International Transmission Shocks," CAMA Working Papers 2007-01, Australian National University, Centre for Applied Macroeconomic Analysis. [Downloadable!]
  13. Richard Clarida & Jordi Gali & Mark Gertler, 2002. "A Simple Framework for International Monetary Policy Analysis," NBER Working Papers 8870, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  14. Richard Clarida & Jordi Gali & Mark Gertler, 2001. "Optimal Monetary Policy in Open versus Closed Economies: An Integrated Approach," American Economic Review, American Economic Association, vol. 91(2), pages 248-252, May. [Downloadable!] (restricted)
  15. Preston, Bruce, 2005. "Learning about Monetary Policy Rules when Long-Horizon Expectations Matter," MPRA Paper 830, University Library of Munich, Germany. [Downloadable!]
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  16. Richard Clarida & Jordi Galí & Mark Gertler, 2000. "Monetary Policy Rules And Macroeconomic Stability: Evidence And Some Theory," The Quarterly Journal of Economics, MIT Press, vol. 115(1), pages 147-180, February. [Downloadable!] (restricted)
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  17. George W. Evans & Avik Chakraborty, 2006. "Can Perpetual Learning Explain the Forward Premium Puzzle?," University of Oregon Economics Department Working Papers 2006-8, University of Oregon Economics Department, revised 20 Aug 2006. [Downloadable!]
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  18. Milani, Fabio, 2007. "Expectations, learning and macroeconomic persistence," Journal of Monetary Economics, Elsevier, vol. 54(7), pages 2065-2082, October. [Downloadable!] (restricted)
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  19. Benigno, Pierpaolo, 2004. "Optimal monetary policy in a currency area," Journal of International Economics, Elsevier, vol. 63(2), pages 293-320, July. [Downloadable!] (restricted)
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  20. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September. [Downloadable!] (restricted)
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  1. Yu-chin Chen & Pisut Kulthanavit, 2007. "Adaptive Learning and Monetary Policy: Lessons from Japan," Working Papers UWEC-2008-12, University of Washington, Department of Economics. [Downloadable!]
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