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Imperfect Knowledge, Adaptive Learning, and the Bias Against Activist Monetary Policies

  • Alberto Locarno

    (Research Department, Banca d'Italia and London School of Economics)

The paper studies the implications for the effectiveness of discretionary monetary policymaking of departing from the assumption of rational expectations. Society, whose welfare function is quadratic, can appoint a central banker whose preferences are either quadratic or lexicographic, to achieve the best mix of inflation and output stability. The focus on lexicographic preferences is justified on the grounds that they imply a strict ordering of policy objectives, which is typical of the mandate of several central banks. Both the private sector and the monetary policymaker have incomplete knowledge of the working of the economy and rely upon adaptive learning to form expectations and decide policy moves. The model economy is assumed to be subject to recurrent unobserved shifts, and the monetary authority, who has private information on the shocks hitting the economy, cannot credibly commit. The main finding of the paper is that when agents rely on an adaptive learning technology, a bias against activist policies arises. The paper also shows that when society has quadratic utility, a strategy based on a strict ordering of objectives is close to optimal for a wide range of values of the inflation aversion parameter.

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Article provided by International Journal of Central Banking in its journal International Journal of Central Banking.

Volume (Year): 3 (2007)
Issue (Month): 3 (September)
Pages: 47-85

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Handle: RePEc:ijc:ijcjou:y:2007:q:3:a:2
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  1. Evans, George W. & Honkapohja, Seppo, 2001. "Expectations and the Stability Problem for Optimal Monetary Policies," CEPR Discussion Papers 2805, C.E.P.R. Discussion Papers.
  2. Lars E. O. Svensson & Michael Woodford, 2000. "Indicator variables for optimal policy," Proceedings, Federal Reserve Bank of San Francisco.
  3. Albert Marcet & Thomas J. Sargent, 1992. "Speed of convergence of recursive least squares learning with ARMA perceptions," Economics Working Papers 15, Department of Economics and Business, Universitat Pompeu Fabra.
  4. Martin Ellison & Natacha Valla, 2000. "Learning, Uncertainty And Central Bank Activism In An Economy With Strategic Interactions," Computing in Economics and Finance 2000 183, Society for Computational Economics.
  5. Bray, Margaret, 1982. "Learning, estimation, and the stability of rational expectations," Journal of Economic Theory, Elsevier, vol. 26(2), pages 318-339, April.
  6. Frederic S. Mishkin & Niklas J. Westelius, 2008. "Inflation Band Targeting and Optimal Inflation Contracts," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(4), pages 557-582, 06.
  7. William A. Branch & Charles T. Carlstrom & George W. Evans & Bruce McGough, 2004. "Monetary policy, endogenous inattention, and the volatility trade-off," Working Paper 0411, Federal Reserve Bank of Cleveland.
  8. Wieland, Volker, 2003. "Monetary Policy and Uncertainty about the Natural Unemployment Rate," CFS Working Paper Series 2003/05, Center for Financial Studies (CFS).
  9. Orphanides, Athanasios & Williams, John C., 2003. "Imperfect knowledge, inflation expectations, and monetary policy," CFS Working Paper Series 2003/40, Center for Financial Studies (CFS).
  10. Charles Goodhart & Margaret Bray, 2002. "You Might as Well be Hung for a Sheep as a Lamb: The Loss Function of an Agent," FMG Discussion Papers dp418, Financial Markets Group.
  11. Giuseppe Ferrero, 2004. "Monetary Policy and the Transition to Rational Expectations," Temi di discussione (Economic working papers) 499, Bank of Italy, Economic Research and International Relations Area.
  12. Marcet, Albert & Sargent, Thomas J., 1989. "Convergence of least squares learning mechanisms in self-referential linear stochastic models," Journal of Economic Theory, Elsevier, vol. 48(2), pages 337-368, August.
  13. Buiter, Willem H., 2006. "How Robust is the New Conventional Wisdom? The Surprising Fragility of the Theoretical Foundations of Inflation Targeting and Central Bank Independence," CEPR Discussion Papers 5772, C.E.P.R. Discussion Papers.
  14. Orphanides, Athanasios & Wieland, Volker, 1999. "Inflation zone targeting," Working Paper Series 0008, European Central Bank.
  15. Orphanides, Athanasios & Wilcox, David W, 2002. "The Opportunistic Approach to Disinflation," International Finance, Wiley Blackwell, vol. 5(1), pages 47-71, Spring.
  16. Bertocchi, Graziella & Spagat, Michael, 1991. "Learning, Experimentation and Monetary Policy," Discussion Papers (IRES - Institut de Recherches Economiques et Sociales) 1991018, Université catholique de Louvain, Institut de Recherches Economiques et Sociales (IRES).
  17. al-Nowaihi, Ali & Stracca, Livio, 2002. "Non-standard central bank loss functions, skewed risks, and certainty equivalence," Working Paper Series 0129, European Central Bank.
  18. Driffill, John & Rotondi, Zeno, 2004. "Monetary Policy and Lexicographic Preference Ordering," CEPR Discussion Papers 4247, C.E.P.R. Discussion Papers.
  19. Ronald J. Balvers & Thomas F. Cosimano, 1994. "Inflation Variability and Gradualist Monetary Policy," Review of Economic Studies, Oxford University Press, vol. 61(4), pages 721-738.
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