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Monetary policy and heterogeneous expectations

  • William Branch

    ()

  • George Evans

    ()

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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  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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