Monetary policy of the Bank of Russia under diagnostic expectations

The paper examines how diagnostic expectations — that is, agents’ excessive reaction to recent information — affect the effectiveness of monetary policy in the Russian economy. To investigate this, we rely on a DSGE model that allows for an alternative mechanism of expectation formation. We calibrate the model to Russian macroeconomic data using Bayesian parameter estimation methods. Our results are as follows: (1) the model incorporating diagnostic expectations fits Russian data better than the model based on full rationality of economic agents; (2) diagnostic expectations alter the operation of the monetary policy transmission mechanism, amplifying inflationary pressures when the key policy rate is reduced; (3) if this change is ignored, relying on the (inaccurate) assumption of rational expectations, monetary easing may lead to excessively high inflation. In the paper, we show how the monetary policy rule should be refined to avoid this undesirable effect.