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New Keynesian Model Dynamics under Heterogeneous Expectations and Adaptive Learning

  • Martin Fukac

We analyze the economic dynamics in a basic New Keynesian model adjusted for imperfect, heterogeneous knowledge and adaptive learning. The policy, represented by a forward-looking Taylor rule, is driven by the central bank's own internal forecasts, whereas the core economic dynamics are driven by private agents' expectations. We study the implications of disagreement between those two. We find that if there is expectations heterogeneity, monetary policy should be less active in its actions in order to be short-run stability improving, and to affect positively the speed of convergence towards the first best equilibrium in the long run. This is in contrast to the homogeneous incomplete knowledge literature, which predicts the opposite. We also find that the homogeneous expectations economy is easier to operate in for monetary policy, and that policy can be more effective than in the heterogeneous expectations economy. From the perspective of incomplete, heterogeneous knowledge and adaptive learning methodology, we can thus see the importance of good communication policy and monetary policy credibility.

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Paper provided by Czech National Bank, Research Department in its series Working Papers with number 2006/5.

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Date of creation: Oct 2006
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Handle: RePEc:cnb:wpaper:2006/5
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  1. Athanasios Orphanides & John C. Williams, 2003. "Imperfect Knowledge, Inflation Expectations, and Monetary Policy," NBER Working Papers 9884, National Bureau of Economic Research, Inc.
  2. Richard Clarida & Jordi Gali & Mark Gertler, 1998. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," NBER Working Papers 6442, National Bureau of Economic Research, Inc.
  3. N. Gregory Mankiw & Ricardo Reis & Justin Wolfers, 2004. "Disagreement about Inflation Expectations," NBER Chapters, in: NBER Macroeconomics Annual 2003, Volume 18, pages 209-270 National Bureau of Economic Research, Inc.
  4. James Bullard & Kaushik Mitra, 2002. "Learning about monetary policy rules," Working Papers 2000-001, Federal Reserve Bank of St. Louis.
  5. Honkapohja, Seppo & Mitra, Kaushik, 2002. "Performance of monetary policy with internal central bank forecasting," Working Paper Series 0127, European Central Bank.
  6. Fuerst, Timothy S., 1992. "Liquidity, loanable funds, and real activity," Journal of Monetary Economics, Elsevier, vol. 29(1), pages 3-24, February.
  7. Giuseppe Ferrero, 2004. "Monetary Policy and the Transition to Rational Expectations," Econometric Society 2004 North American Summer Meetings 101, Econometric Society.
  8. Milani, Fabio, 2007. "Expectations, learning and macroeconomic persistence," Journal of Monetary Economics, Elsevier, vol. 54(7), pages 2065-2082, October.
  9. Preston, Bruce, 2006. "Adaptive learning, forecast-based instrument rules and monetary policy," Journal of Monetary Economics, Elsevier, vol. 53(3), pages 507-535, April.
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