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Non-rational expectations and the transmission mechanism

Author

Listed:
  • Harrison, Richard

    () (Bank of England)

  • Taylor, Tim

    () (Bank of England)

Abstract

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.

Suggested Citation

  • Harrison, Richard & Taylor, Tim, 2012. "Non-rational expectations and the transmission mechanism," Bank of England working papers 448, Bank of England.
  • Handle: RePEc:boe:boeewp:0448
    as

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    References listed on IDEAS

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    1. Nelson, Edward & Nikolov, Kalin, 2004. "Monetary Policy and Stagflation in the UK," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 36(3), pages 293-318, June.
    2. Robertson, John C & Tallman, Ellis W & Whiteman, Charles H, 2005. "Forecasting Using Relative Entropy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 37(3), pages 383-401, June.
    3. Bruce Preston, 2005. "Learning about Monetary Policy Rules when Long-Horizon Expectations Matter," International Journal of Central Banking, International Journal of Central Banking, vol. 1(2), September.
    4. Bullard, James & Mitra, Kaushik, 2002. "Learning about monetary policy rules," Journal of Monetary Economics, Elsevier, vol. 49(6), pages 1105-1129, September.
    5. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 2005. "Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy," Journal of Political Economy, University of Chicago Press, vol. 113(1), pages 1-45, February.
    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. Alex Brazier & Richard Harrison & Mervyn King & Tony Yates, 2008. "The Danger of Inflating Expectations of Macroeconomic Stability: Heuristic Switching in an Overlapping-Generations Monetary Model," International Journal of Central Banking, International Journal of Central Banking, vol. 4(2), pages 219-254, June.
    9. 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.
    10. 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.
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    Cited by:

    1. Burgess, Stephen & Fernandez-Corugedo, Emilio & Groth, Charlotta & Harrison, Richard & Monti, Francesca & Theodoridis, Konstantinos & Waldron, Matt, 2013. "The Bank of England's forecasting platform: COMPASS, MAPS, EASE and the suite of models," Bank of England working papers 471, Bank of England.
    2. Tim Taylor & Richard Harrison, 2008. "Misperceptions, heterogeneous expectations and macroeconomic dynamics," 2008 Meeting Papers 710, Society for Economic Dynamics.

    More about this item

    Keywords

    Expectations; monetary transmission mechanism;

    JEL classification:

    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • E17 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Forecasting and Simulation: Models and Applications

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