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Monetary policy and heterogeneous expectations

Author Info

  • William Branch

    ()

  • George Evans

    ()

Abstract

This paper studies the implications for monetary policy of heterogeneous expectations in a New Keynesian model. The assumption of rational expec?tations is replaced with parsimonious forecasting models where agents select between predictors that are underparameterized. In a Misspecification Equilib?rium agents only select the best-performing statistical models. We demonstrate that, even when monetary policy rules satisfy the Taylor principle by adjusting nominal interest rates more than one for one with inflation, there may exist equilibria with Intrinsic Heterogeneity. Under certain conditions, there may exist multiple misspecification equilibria. We show that these findings have im?portant implications for business cycle dynamics and for the design of monetary policy.

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File URL: http://hdl.handle.net/10.1007/s00199-010-0539-9
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Article provided by Springer in its journal Economic Theory.

Volume (Year): 47 (2011)
Issue (Month): 2 (June)
Pages: 365-393

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Handle: RePEc:spr:joecth:v:47:y:2011:i:2:p:365-393
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Keywords: Heterogeneous expectations; Monetary policy; Multiple equilibria; Adaptive learning; G12; G14; D82; D83;

Other versions of this item:

Find related papers by JEL classification:
  • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
  • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
  • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
  • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness

References listed on IDEAS
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  1. Bill Branch & George W. Evans, 2003. "Intrinsic Heterogeneity in Expectation Formation," University of Oregon Economics Department Working Papers 2003-32, University of Oregon Economics Department, revised 04 Oct 2004.
  2. Bennett T. McCallum, 1997. "Issues in the Design of Monetary Policy Rules," NBER Working Papers 6016, National Bureau of Economic Research, Inc.
  3. Ernst Fehr & Jean-Robert Tyran, 2008. "Limited Rationality and Strategic Interaction: The Impact of the Strategic Environment on Nominal Inertia," Econometrica, Econometric Society, vol. 76(2), pages 353-394, 03.
  4. George W. Evans & Seppo Honkapohja, 2003. "Expectations and the Stability Problem for Optimal Monetary Policies," Review of Economic Studies, Oxford University Press, vol. 70(4), pages 807-824.
  5. repec:att:wimass:9530 is not listed on IDEAS
  6. Kurz, Mordecai, 1994. "On the Structure and Diversity of Rational Beliefs," Economic Theory, Springer, vol. 4(6), pages 877-900, October.
  7. Mordecai Kurz & Maurizio Motolese, 2011. "Diverse beliefs and time variability of risk premia," Economic Theory, Springer, vol. 47(2), pages 293-335, June.
  8. Christopher A. Sims & Tao Zha, 2005. "Were There Regime Switches in U.S. Monetary Policy?," Working Papers 92, Princeton University, Department of Economics, Center for Economic Policy Studies..
  9. Clarida, R. & Gali, J. & Gertler, M., 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Working Papers 99-13, C.V. Starr Center for Applied Economics, New York University.
  10. Young, H. Peyton, 2004. "Strategic Learning and its Limits," OUP Catalogue, Oxford University Press, number 9780199269181.
  11. William A. Brock & Cars H. Hommes, 1997. "A Rational Route to Randomness," Econometrica, Econometric Society, vol. 65(5), pages 1059-1096, September.
  12. William A. Branch & George W. Evans, 2010. "Asset Return Dynamics and Learning," Review of Financial Studies, Society for Financial Studies, vol. 23(4), pages 1651-1680, April.
  13. James Bullard & Kaushik Mitra, 2002. "Learning about monetary policy rules," Working Papers 2000-001, Federal Reserve Bank of St. Louis.
  14. George W. Evans & William A. Branch, 2005. "Model Uncertainty and Endogenous Volatility," Computing in Economics and Finance 2005 33, Society for Computational Economics.
  15. Kurz, Mordecai & Jin, Hehui & Motolese, Maurizio, 2003. "The role of expectations in economic fluctuations and the efficacy of monetary policy," CFS Working Paper Series 2003/42, Center for Financial Studies (CFS).
  16. William Branch & Bruce McGough, 2011. "Business cycle amplification with heterogeneous expectations," Economic Theory, Springer, vol. 47(2), pages 395-421, June.
  17. Thomas J Sargent, 2007. "Evolution and Intelligent Design," Levine's Bibliography 122247000000001821, UCLA Department of Economics.
  18. Volker Wieland & Maik Wolters, 2011. "The diversity of forecasts from macroeconomic models of the US economy," Economic Theory, Springer, vol. 47(2), pages 247-292, June.
  19. William A. Branch, 2004. "The Theory of Rationally Heterogeneous Expectations: Evidence from Survey Data on Inflation Expectations," Economic Journal, Royal Economic Society, vol. 114(497), pages 592-621, 07.
  20. Branch, William A. & McGough, Bruce, 2009. "A New Keynesian model with heterogeneous expectations," Journal of Economic Dynamics and Control, Elsevier, vol. 33(5), pages 1036-1051, May.
  21. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
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Cited by:

  1. Bofinger, Peter & Debes, Sebastian & Gareis, Johannes & Mayer, Eric, 2013. "Monetary policy transmission in a model with animal spirits and house price booms and busts," Journal of Economic Dynamics and Control, Elsevier, vol. 37(12), pages 2862-2881.
  2. John Knight & Stephen Satchell & Nandini Srivastava, 2012. "Steady-State Distributions for Models of Bubbles: their Existence and Econometric Implications," Birkbeck Working Papers in Economics and Finance 1208, Birkbeck, Department of Economics, Mathematics & Statistics.
  3. Mordecai Kurz, 2011. "Symposium: on the role of market belief in economic dynamics, an introduction," Economic Theory, Springer, vol. 47(2), pages 189-204, June.
  4. Paul De Grauwe, 2010. "Top-Down versus Bottom-Up Macroeconomics," CESifo Working Paper Series 3020, CESifo Group Munich.
  5. Roger Guesnerie & Pedro Jara-Moroni, 2011. "Expectational coordination in simple economic contexts," Economic Theory, Springer, vol. 47(2), pages 205-246, June.
  6. Wieland, Volker & Wolters, Maik H., 2010. "The diversity of forecasts from macroeconomic models of the U.S. economy," CFS Working Paper Series 2010/08, Center for Financial Studies (CFS).
  7. Paul Grauwe, 2011. "Animal spirits and monetary policy," Economic Theory, Springer, vol. 47(2), pages 423-457, June.
  8. Knight, John & Satchell, Stephen & Srivastava, Nandini, 2014. "Steady state distributions for models of locally explosive regimes: Existence and econometric implications," Economic Modelling, Elsevier, vol. 41(C), pages 281-288.
  9. Man-Keung Tang & Xiangrong Yu, 2011. "Communication of Central Bank Thinking and Inflation Dynamics," IMF Working Papers 11/209, International Monetary Fund.
  10. Gomes, Orlando, 2006. "The dynamics of television advertising with boundedly rational consumers," MPRA Paper 2847, University Library of Munich, Germany.
  11. Carsten Nielsen, 2011. "Price stabilizing, Pareto improving policies," Economic Theory, Springer, vol. 47(2), pages 459-500, June.
  12. Joseph Haslag & William Brock, 2014. "On Understanding the Cyclical Behavior of the Price Level and Inflation," Working Papers 1404, Department of Economics, University of Missouri, revised 01 Jul 2014.
  13. Gomes, Orlando, 2006. "Nonlinear inflation expectations and endogenous fluctuations," MPRA Paper 2842, University Library of Munich, Germany.
  14. Machado, Vicente da Gama, 2013. "Monetary policy rules, asset prices and adaptive learning," Journal of Financial Stability, Elsevier, vol. 9(3), pages 251-258.
  15. Vicente da Gama Machado, 2012. "Monetary Policy, Asset Prices and Adaptive Learning," Working Papers Series 274, Central Bank of Brazil, Research Department.
  16. William Branch & Bruce McGough, 2011. "Business cycle amplification with heterogeneous expectations," Economic Theory, Springer, vol. 47(2), pages 395-421, June.

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