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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. Lars E.O. Svensson & Michael Woodford, 2000. "Indicator Variables for Optimal Policy," NBER Working Papers 7953, National Bureau of Economic Research, Inc.
  2. 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.
  3. Giuseppe Ferrero, 2004. "Monetary policy and the transition to rational expectations," Computing in Economics and Finance 2004 19, Society for Computational Economics.
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  5. Bertocchi, Graziella & Spagat, Michael, 1993. "Learning, experimentation, and monetary policy," Journal of Monetary Economics, Elsevier, vol. 32(1), pages 169-183, August.
  6. repec:cup:cbooks:9780521671071 is not listed on IDEAS
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  8. George W. Evans & Seppo Honkapohja, 2003. "Expectations and the Stability Problem for Optimal Monetary Policies," Review of Economic Studies, Wiley Blackwell, vol. 70(4), pages 807-824, October.
  9. Bray, Margaret, 1982. "Learning, estimation, and the stability of rational expectations," Journal of Economic Theory, Elsevier, vol. 26(2), pages 318-339, April.
  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. Ellison, Martin & Valla, Natacha, 2001. "Learning, uncertainty and central bank activism in an economy with strategic interactions," Journal of Monetary Economics, Elsevier, vol. 48(1), pages 153-171, August.
  12. Orphanides, Athanasios & Wieland, Volker, 1999. "Inflation zone targeting," Working Paper Series 0008, European Central Bank.
  13. Frederic S. Mishkin & Niklas J. Westelius, 2006. "Inflation Band Targeting and Optimal Inflation Contracts," NBER Working Papers 12384, National Bureau of Economic Research, Inc.
  14. 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.
  15. 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.
  16. Volker Wieland, 1998. "Monetary policy and uncertainty about the natural unemployment rate," Finance and Economics Discussion Series 1998-22, Board of Governors of the Federal Reserve System (U.S.).
  17. Balvers, Ronald J & Cosimano, Thomas F, 1994. "Inflation Variability and Gradualist Monetary Policy," Review of Economic Studies, Wiley Blackwell, vol. 61(4), pages 721-38, October.
  18. Driffill, John & Rotondi, Zeno, 2004. "Monetary Policy and Lexicographic Preference Ordering," CEPR Discussion Papers 4247, C.E.P.R. Discussion Papers.
  19. Orphanides, Athanasios & Wilcox, David W, 2002. "The Opportunistic Approach to Disinflation," International Finance, Wiley Blackwell, vol. 5(1), pages 47-71, Spring.
  20. al-Nowaihi, Ali & Stracca, Livio, 2002. "Non-standard central bank loss functions, skewed risks, and certainty equivalence," Working Paper Series 0129, European Central Bank.
  21. repec:cup:cbooks:9780521854863 is not listed on IDEAS
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