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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. Athanasios Orphanides & John Williams, 2004. "Imperfect Knowledge, Inflation Expectations, and Monetary Policy," NBER Chapters, in: The Inflation-Targeting Debate, pages 201-246 National Bureau of Economic Research, Inc.
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  5. 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.
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  15. William A. Branch & John Carlson & George W. Evans & Bruce McGough, 2004. "Monetary policy, endogenous inattention, and the volatility trade-off," Working Paper 0411, Federal Reserve Bank of Cleveland.
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  17. 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.
  18. Giuseppe Ferrero, 2004. "Monetary Policy and the Transition to Rational Expectations," Econometric Society 2004 North American Summer Meetings 101, Econometric Society.
  19. Bray, Margaret, 1982. "Learning, estimation, and the stability of rational expectations," Journal of Economic Theory, Elsevier, vol. 26(2), pages 318-339, April.
  20. 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.
  21. Orphanides, Athanasios & Wilcox, David W, 2002. "The Opportunistic Approach to Disinflation," International Finance, Wiley Blackwell, vol. 5(1), pages 47-71, Spring.
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