Inflation Targeting, Recursive Inattentiveness and Heterogeneous Beliefs

In this paper we consider a scenario in which the monetary authority provides an explicit inflation target in order to anchor private sector expectations and align them with policy objectives. In this context, a biased perception of the target may arise due to imperfect information flows and idiosyncrasies in information processing lead to heterogenous beliefs about the target. We allow private sector expectations to be revised over time as new information becomes available and the direction of change is determined by the distance between agents' beliefs and actual realizations of macro variables. The recursive choice between alternative predictors is modeled as an optimization problem under rational inattention. Within this framework we investigate whether a simple interest rate rule can steer the economy toward the targeted equilibrium. Our findings suggest that standard policy advices, i.e., ensure determinacy under rational expectations, may not be sufficient to reach the target. Instead, a sound monetary policy should be fine-tuned to ensure that the signal sent by realizations of macro variables can correct biased agents' beliefs.