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The role of expectations in economic fluctuations and the efficacy of monetary policy

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  • Kurz, Mordecai
  • Jin, Hehui
  • Motolese, Maurizio

Abstract

We show diverse beliefs is an important propagation mechanism of fluctuations, money non neutrality and efficacy of monetary policy. Since expectations affect demand, our theory shows economic fluctuations are mostly driven by varying demand not supply shocks. Using a competitive model with flexible prices in which agents hold Rational Belief (see Kurz (1994)) we show that (i) our economy replicates well the empirical record of fluctuations in the U.S. (ii) Under monetary rules without discretion, monetary policy has a strong stabilization effect and an aggressive anti-inflationary policy can reduce inflation volatility to zero. (iii) The statistical Phillips Curve changes substantially with policy instruments and activist policy rules render it vertical. (iv) Although prices are flexible, money shocks result in less than proportional changes in inflation hence the aggregate price level appears “sticky” with respect to money shocks. (v) Discretion in monetary policy adds a random element to policy and increases volatility. The impact of discretion on the efficacy of policy depends upon the structure of market beliefs about future discretionary decisions. We study two rationalizable beliefs. In one case, market beliefs weaken the effect of policy and in the second, beliefs bolster policy outcomes and discretion could be a desirable attribute of the policy rule. Since the central bank does not know any more than the private sector, real social gain from discretion arise only in extraordinary cases. Hence, the weight of the argument leads us to conclude that bank’s policy should be transparent and abandon discretion except for rare and unusual circumstances. (vi) An implication of our model suggests the current effective policy is only mildly activist and aims mostly to target inflation. --

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Bibliographic Info

Paper provided by Center for Financial Studies (CFS) in its series CFS Working Paper Series with number 2003/42.

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Date of creation: 2003
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Handle: RePEc:zbw:cfswop:200342

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Keywords: Monetary policy rules; Money non neutrality; Business cycles; Market volatility; Propagation mechanism; Capacity utilization; Heterogenous beliefs; Over confidence; Rational Belief; Optimism; Pessimism; Non stationarity; Empirical distribution;

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Citations

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Cited by:
  1. Hiroyuki Nakata, 2007. "A Model of Financial Markets with Endogenously Correlated Rational Beliefs," Economic Theory, Springer, Springer, vol. 30(3), pages 431-452, March.
  2. Kurz, Mordecai & Piccillo, Giulia & Wu, Howei, 2013. "Modeling diverse expectations in an aggregated New Keynesian Model," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 37(8), pages 1403-1433.
  3. Wieland, Volker & Wolters, Maik H, 2010. "The Diversity of Forecasts from Macroeconomic Models of the U.S. Economy," CEPR Discussion Papers, C.E.P.R. Discussion Papers 7870, C.E.P.R. Discussion Papers.
  4. 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.
  5. Schmidt, Sebastian & Wieland, Volker, 2012. "The new keynesian approach to dynamic general equilibrium modeling: Models, methods, and macroeconomic policy evaluation," IMFS Working Paper Series, Institute for Monetary and Financial Stability (IMFS), Goethe University Frankfurt 52, Institute for Monetary and Financial Stability (IMFS), Goethe University Frankfurt.
  6. Marco Celentani & J. Ignacio Conde-Ruiz & Klaus Desmet, . "Inflation in open economies with complete markets," Working Papers 2004-12, FEDEA.
  7. William A. Branch & George W. Evans, 2010. "Monetary Policy and Heterogeneous Expectations," CDMA Working Paper Series, Centre for Dynamic Macroeconomic Analysis 201011, Centre for Dynamic Macroeconomic Analysis.
  8. Kurz, Mordecai, 2008. "Beauty contests under private information and diverse beliefs: How different?," Journal of Mathematical Economics, Elsevier, vol. 44(7-8), pages 762-784, July.
  9. Francesco Caprioli & Pietro Rizza & Pietro Tommasino, 2012. "Optimal fiscal policy when agents fear government default," Temi di discussione (Economic working papers), Bank of Italy, Economic Research and International Relations Area 859, Bank of Italy, Economic Research and International Relations Area.
  10. Mordecai Kurz & Maurizio Motolese, 2011. "Diverse beliefs and time variability of risk premia," Economic Theory, Springer, Springer, vol. 47(2), pages 293-335, June.
  11. Kyrtsou, Catherine & Malliaris, Anastasios G., 2009. "The impact of information signals on market prices when agents have non-linear trading rules," Economic Modelling, Elsevier, Elsevier, vol. 26(1), pages 167-176, January.
  12. Mordecai Kurz, 2007. "Rational Diverse Beliefs and Economic Volatility," Discussion Papers, Stanford Institute for Economic Policy Research 06-045, Stanford Institute for Economic Policy Research.
  13. Mordecai Kurz, 2005. "Measuring the Ex-Ante Social Cost of Aggregate Volatility," Discussion Papers, Stanford Institute for Economic Policy Research 04-006, Stanford Institute for Economic Policy Research.
  14. Hiroyuki Nakata, 2013. "Welfare effects of short-sale constraints under heterogeneous beliefs," Economic Theory, Springer, Springer, vol. 53(2), pages 283-314, June.
  15. William Branch & Bruce McGough, 2011. "Business cycle amplification with heterogeneous expectations," Economic Theory, Springer, Springer, vol. 47(2), pages 395-421, June.
  16. Branch, William A. & Evans, George W., 2010. "Monetary Policy and Heterogeneous Expectations," SIRE Discussion Papers, Scottish Institute for Research in Economics (SIRE) 2010-32, Scottish Institute for Research in Economics (SIRE).

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