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Heterogenous Information About the Term Structure of Interest Rates, Least-Squares Learning and Optimal Interest Rate Rules

  • Eijffinger, Sylvester C W
  • Schaling, Eric
  • Tesfaselassie, Mewael F.

In this Paper we incorporate the term structure of interest rates in a standard inflation forecast targeting framework. Learning about the transmission process of monetary policy is introduced by having heterogeneous agents - i.e. the 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 and has to learn the private sector forecasting rule for short-term interest rates. 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.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 4279.

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Date of creation: Mar 2004
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Handle: RePEc:cpr:ceprdp:4279
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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. 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.
  3. Wieland, Volker, 1999. "Monetary policy, parameter uncertainty and optimal learning," ZEI Working Papers B 09-1999, ZEI - Center for European Integration Studies, University of Bonn.
  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. repec:ner:tilbur:urn:nbn:nl:ui:12-86472 is not listed on IDEAS
  6. Kaushik Mitra, . "Desirability of Nominal GDP Targeting Under Adaptive Learning," Discussion Papers 00/60, Department of Economics, University of York.
  7. Athanasios Orphanides & John C. Williams, 2002. "Imperfect knowledge, inflation expectations, and monetary policy," Working Paper Series 2002-04, Federal Reserve Bank of San Francisco.
  8. Eric Schaling, 1999. "The non-linear Phillips curve and inflation forecast targeting," Bank of England working papers 98, Bank of England.
  9. Eijffinger, Sylvester C W & Schaling, Eric & Verhagen, Willem, 2000. "The Term Structure of Interest Rates and Inflation Forecast Targeting," CEPR Discussion Papers 2375, C.E.P.R. Discussion Papers.
  10. Eric Schaling, James Bullard, 2001. "New economy : new policy rules?," Computing in Economics and Finance 2001 53, Society for Computational Economics.
  11. 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.
  12. Eric Schaling, 2004. "Learning, inflation expectations and optimal monetary policy," Macroeconomics 0404035, EconWPA.
  13. 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 571-86, August.
  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. 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 219-39, March.
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