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Two-sided Learning and Optimal Monetary Policy in an Open Economy Model

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  • Timothy Kam

    (UWA Business School, The University of Western Australia)

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    Abstract

    In this paper, we consider a dynamic New Keynesian model of the small open economy in the light of bounded rationality. This entails private agents and the central bank updating their beliefs about the laws of motion of inflation, the output gap and real exchange rate, when forming their optimal decisions. It is shown that when all players learn using recursive least-squares or stochastic-gradient adaptive algorithms, the optimal policy steers the economy towards a rational expectations equilibrium (REE) with probability one in some cases. This is also the case when only private agents are learning. However there also exists structural parameter values in the true model such that learning converges with probability zero to REE.

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    File URL: http://www.biz.uwa.edu.au/home/research/discussionworking_papers/economics/2004?f=150997
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    Bibliographic Info

    Paper provided by The University of Western Australia, Department of Economics in its series Economics Discussion / Working Papers with number 04-07.

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    Length: 27 pages
    Date of creation: 2004
    Date of revision:
    Handle: RePEc:uwa:wpaper:04-07

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    Related research

    Keywords: Optimal monetary policy; Small open economy; Learning; Stochastic approximation;

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    References

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    1. Honkapohja, Seppo & Evans, George W., 2000. "Expectations and the stability problem for optimal monetary policies," Discussion Paper Series 1: Economic Studies 2000,10, Deutsche Bundesbank, Research Centre.
    2. Jordi Galí & Tommaso Monacelli, 2004. "Monetary policy and exchange rate volatility in a small open economy," Economics Working Papers 835, Department of Economics and Business, Universitat Pompeu Fabra.
    3. 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.
    4. Lars E. O. Svensson & Michael Woodford, 2003. "Implementing Optimal Policy through Inflation-Forecast Targeting," NBER Working Papers 9747, National Bureau of Economic Research, Inc.
    5. Sargent, Thomas J & Wallace, Neil, 1975. ""Rational" Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule," Journal of Political Economy, University of Chicago Press, vol. 83(2), pages 241-54, April.
    6. Kaushik Mitra & James Bullard, . "Learning About Monetary Policy Rules," Discussion Papers 00/41, Department of Economics, University of York.
    7. Ben S. Bernanke & Michael Woodford, 1997. "Inflation forecasts and monetary policy," Proceedings, Federal Reserve Bank of Cleveland, pages 653-686.
    8. Tommaso Monacelli, 2003. "Monetary Policy in a Low Pass-Through Environment," Working Papers 228, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
    9. Barro, Robert J. & Gordon, David B., 1983. "Rules, discretion and reputation in a model of monetary policy," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 101-121.
    10. Kuan, Chung-Ming & White, Halbert, 1994. "Adaptive Learning with Nonlinear Dynamics Driven by Dependent Processes," Econometrica, Econometric Society, vol. 62(5), pages 1087-1114, September.
    11. 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.
    12. Jordi Gali & Tommaso Monacelli, 1999. "Optimal Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Boston College Working Papers in Economics 438, Boston College Department of Economics, revised 15 Nov 1999.
    13. Lars Peter Hansen & Thomas J. Sargent, 2001. "Acknowledging Misspecification in Macroeconomic Theory," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 4(3), pages 519-535, July.
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    Cited by:
    1. Fujisaki, Seiya, 2012. "Interest Rate Control Rules and Macroeconomic Stability in a Heterogeneous Two-Country Model," MPRA Paper 37017, University Library of Munich, Germany.
    2. Fujisaki, Seiya, 2013. "Taylor rules and equilibrium determinacy in a two-country model with non-traded goods," Economic Modelling, Elsevier, vol. 35(C), pages 597-603.

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