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Heterogenous information about the term structure, least-squares learning and optimal rules for inflation targeting

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  • Schaling, Eric
  • Eijffinger, Sylvester
  • Tesfaselassie, Mewael

Abstract

In this paper we incorporate the term structure of interest rates into a standard inflation forecast targeting framework.Learning about the transmission process of monetary policy is introduced by having heterogeneous agents - ie central bank and private agents - who have different information sets about the future sequence of short-term interest rates.We analyse inflation forecast targeting in two environments.One in which the central bank has perfect knowledge, in the sense that it understands and observes the process by which private sector interest rate expectations are generated, and one in which the central bank has imperfect knowledge.In the case of imperfect knowledge, the central bank has to learn about private sector interest rate expectations, as the latter affect the impact of monetary policy through the expectations theory of the term structure of interest rates.Here, following Evans and Honkapohja (2001), the learning scheme we investigate is that of least-squares learning (recursive OLS) using the Kalman filter.We find that optimal monetary policy under learning is a policy that separates estimation and control.Therefore, this model suggests that the practical relevance of the breakdown of the separation principle and the need for experimentation in policy may be limited. Key words: learning, rational expectations, separation principle, Kalman filter, term structure of interest rates JEL classification numbers: C53, E43, E52, F33

Suggested Citation

  • Schaling, Eric & Eijffinger, Sylvester & Tesfaselassie, Mewael, 2004. "Heterogenous information about the term structure, least-squares learning and optimal rules for inflation targeting," Research Discussion Papers 23/2004, Bank of Finland.
  • Handle: RePEc:bof:bofrdp:2004_023
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    References listed on IDEAS

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    1. Rudebusch, Glenn D. & Svensson, Lars E. O., 2002. "Eurosystem monetary targeting: Lessons from U.S. data," European Economic Review, Elsevier, vol. 46(3), pages 417-442, March.
    2. Schaling, Eric, 2003. "Learning, inflation expectations and optimal monetary policy," Research Discussion Papers 20/2003, Bank of Finland.
    3. Mark Gertler & Jordi Gali & Richard Clarida, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December.
    4. James B. Bullard, 1991. "Learning, rational expectations and policy: a summary of recent research," Review, Federal Reserve Bank of St. Louis, issue Jan, pages 50-60.
    5. Wieland, Volker, 2000. "Monetary policy, parameter uncertainty and optimal learning," Journal of Monetary Economics, Elsevier, vol. 46(1), pages 199-228, August.
    6. Mitra, Kaushik, 2003. " Desirability of Nominal GDP Targeting under Adaptive Learning," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 35(2), pages 197-220, April.
    7. Jovanovic, Boyan & Nyarko, Yaw, 1996. "Learning by Doing and the Choice of Technology," Econometrica, Econometric Society, vol. 64(6), pages 1299-1310, November.
    8. Eijffinger, S.C.W. & Schaling, E. & Verhagen, W.H., 1998. "The Term Structure of Interest Rates and Inflation Forecast Targeting," Discussion Paper 1998-85, Tilburg University, Center for Economic Research.
    9. Foster, Andrew D & Rosenzweig, Mark R, 1995. "Learning by Doing and Learning from Others: Human Capital and Technical Change in Agriculture," Journal of Political Economy, University of Chicago Press, vol. 103(6), pages 1176-1209, December.
    10. Beck, Gunter W. & Wieland, Volker, 2002. "Learning and control in a changing economic environment," Journal of Economic Dynamics and Control, Elsevier, vol. 26(9-10), pages 1359-1377, August.
    11. Fuhrer, Jeffrey C & Moore, George R, 1995. "Monetary Policy Trade-offs and the Correlation between Nominal Interest Rates and Real Output," American Economic Review, American Economic Association, vol. 85(1), pages 219-239, March.
    12. James B. Bullard & Eric Schaling, 2001. "New economy-new policy rules," Review, Federal Reserve Bank of St. Louis, issue May, pages 57-66.
    13. Mark Gertler & Jordi Gali & Richard Clarida, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December.
    14. 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.
    15. Sargent, Thomas J., 1993. "Bounded Rationality in Macroeconomics: The Arne Ryde Memorial Lectures," OUP Catalogue, Oxford University Press, number 9780198288695.
    16. Kiefer, Nicholas M & Nyarko, Yaw, 1989. "Optimal Control of an Unknown Linear Process with Learning," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 30(3), pages 571-586, August.
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    Citations

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    Cited by:

    1. Leitemo, Kai & Söderström, Ulf, 2008. "Robust Monetary Policy In The New Keynesian Framework," Macroeconomic Dynamics, Cambridge University Press, vol. 12(S1), pages 126-135, April.
    2. Mikko Puhakka, 2005. "Equilibrium dynamics under lump-sum taxation in an exchange economy with skewed endowments," Macroeconomics 0508033, EconWPA.
    3. Mewael F. Tesfaselassie & Eric Schaling & Sylvester Eijffinger, 2011. "Learning about the Term Structure and Optimal Rules for Inflation Targeting," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 43(8), pages 1685-1706, December.
    4. Suvanto, Antti & Hukkinen, Juhana, 2004. "Stable price level and changing prices," Research Discussion Papers 28/2004, Bank of Finland.
    5. Puhakka, Mikko, 2004. "Equilibrium dynamics under lump-sum taxation in an exchange economy with skewed endowments," Research Discussion Papers 29/2004, Bank of Finland.
    6. Hyytinen, Ari & Takalo, Tuomas, 2004. "Multihoming in the market for payment media : evidence from young Finnish consumers," Research Discussion Papers 25/2004, Bank of Finland.
    7. Antti Suvanto & Juhana Hukkinen, 2005. "Stable price level and changing prices," Macroeconomics 0508034, EconWPA.
    8. Jokivuolle, Esa & Lanne, Markku, 2004. "Trading Nokia : the roles of the Helsinki vs the New York stock exchanges," Research Discussion Papers 26/2004, Bank of Finland.
    9. Leitemo, Kai & Söderström, Ulf, 2004. "Robust monetary policy in the New-Keynesian framework," Research Discussion Papers 31/2004, Bank of Finland.

    More about this item

    JEL classification:

    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions

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