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Non-rational expectations and the transmission mechanism

  • Harrison, Richard

    ()

    (Bank of England)

  • Taylor, Tim

    ()

    (Bank of England)

In this paper, we compare two approaches to modelling behaviour under non-rational expectations in a benchmark New Keynesian model. The ‘Euler equation’ approach modifies the equations derived under the assumption of rational expectations by replacing the rational expectations operator with an alternative assumption about expectations formation. The ‘long-horizon’ expectations approach solves the decision rules of households and firms conditional on their expectations for future events that are outside of their control, so that spending and price-setting decisions depend on expectations extending into the distant future. Both approaches can be defended as descriptions of (distinct) forms of boundedly rational behaviour, but have different implications both for the form of the equations that govern the dynamics of the economy and the ease of deriving those equations. In this paper we construct two versions of a benchmark New Keynesian model in which non-rational expectations are modelled using the Euler equation and long-horizon approaches and show that both approaches have very similar implications for macroeconomic dynamics when departures from rational expectations are relatively small. But as expectations depart further from rationality, the two approaches can generate significantly different implications for the behaviour of key variables.

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Paper provided by Bank of England in its series Bank of England working papers with number 448.

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Length: 51 pages
Date of creation: 18 May 2012
Date of revision:
Handle: RePEc:boe:boeewp:0448
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  1. Lawrence J. Christiano & Martin Eichenbaum & Charles Evans, 2001. "Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy," NBER Working Papers 8403, National Bureau of Economic Research, Inc.
  2. John C. Robertson & Ellis W. Tallman & Charles H. Whiteman, 2002. "Forecasting using relative entropy," Working Paper 2002-22, Federal Reserve Bank of Atlanta.
  3. James Bullard & Kaushik Mitra, 2002. "Learning about monetary policy rules," Working Papers 2000-001, Federal Reserve Bank of St. Louis.
  4. Edward Nelson & Kalin Nikolov, 2002. "Monetary policy and stagflation in the UK," Bank of England working papers 155, Bank of England.
  5. 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.
  6. Cogley, Timothy & Morozov, Sergei & Sargent, Thomas J., 2005. "Bayesian fan charts for U.K. inflation: Forecasting and sources of uncertainty in an evolving monetary system," Journal of Economic Dynamics and Control, Elsevier, vol. 29(11), pages 1893-1925, November.
  7. Tim Taylor & Richard Harrison, 2008. "Misperceptions, heterogeneous expectations and macroeconomic dynamics," 2008 Meeting Papers 710, Society for Economic Dynamics.
  8. Preston, Bruce, 2005. "Learning about Monetary Policy Rules when Long-Horizon Expectations Matter," MPRA Paper 830, University Library of Munich, Germany.
  9. Alex Brazier & Richard Harrison & Mervyn King & Tony Yates, 2006. "The danger of inflating expectations of macroeconomic stability: heuristic switching in an overlapping generations monetary model," Bank of England working papers 303, Bank of England.
  10. Anufriev, M. & Hommes, C.H., 2007. "Evolution of Market Heuristics," CeNDEF Working Papers 07-06, Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance.
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