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Asymmetric information and rational expectations: When is it right to be "wrong"?

  • Demertzis, Maria
  • Hughes Hallett, Andrew

In this paper we examine the effects of private agents being less than fully rational in their expectations. We examine this in the context of monetary policy, where the Central Bank may have uncertain preferences either by choice or by necessity. The new feature is that we allow the public to react in two different ways. They either form rational expectations and internalize the uncertainty about the Central Bank's preferences in full; or alternatively, and if this process of internalization is costly, it forms a 'best' guess regarding those preferences. This implies a certainty equivalence strategy applied to the preference parameters. As those parameters enter the decisions non-linearly, a systematic error emerges. We examine the magnitude of the resulting error in inflation and output, following the assumption of certainty equivalence. Under all reasonable levels of uncertainty, this error turns out to be small but involves trading a deflation bias against the cost of gathering the information needed for the full information rational expectations' solution.

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Article provided by Elsevier in its journal Journal of International Money and Finance.

Volume (Year): 27 (2008)
Issue (Month): 8 (December)
Pages: 1407-1419

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Handle: RePEc:eee:jimfin:v:27:y:2008:i:8:p:1407-1419
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/30443

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  1. Hughes Hallett, A. J., 1984. "On alternative methods of generating risk sensitive decision rules," Economics Letters, Elsevier, vol. 16(1-2), pages 37-44.
  2. Michael Woodford, 2005. "Robustly Optimal Monetary Policy with Near Rational Expectations," NBER Working Papers 11896, National Bureau of Economic Research, Inc.
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  10. Sibert, Anne, 2002. "Monetary policy with uncertain central bank preferences," European Economic Review, Elsevier, vol. 46(6), pages 1093-1109, June.
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  17. Gerdesmeier, Dieter & Roffia, Barbara, 2003. "Empirical estimates of reaction functions for the euro area," Working Paper Series 0206, European Central Bank.
  18. Maria Demertzis & Marco Hoeberichts, 2007. "The Costs of Increasing Transparency," Open Economies Review, Springer, vol. 18(3), pages 263-280, July.
  19. Julio J. Rotemberg & Michael Woodford, 1998. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy: Expanded Version," NBER Technical Working Papers 0233, National Bureau of Economic Research, Inc.
  20. Maria Demertzis & Marco Hoeberichts, 2006. "The Costs of Increasing Transparency," DNB Working Papers 080, Netherlands Central Bank, Research Department.
  21. Rogoff, Kenneth, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, MIT Press, vol. 100(4), pages 1169-89, November.
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