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Forming Rational Expectations and When it is Right to be 'Wrong'

  • Demertzis, Maria
  • Hughes Hallett, Andrew

In this paper we examine the effects of private agents being less than fully rational. We examine this in the context of monetary policy, where the Central Bank may have uncertain preferences either by choice or by necessity. The new feature is that we allow the public to react in two different ways to this uncertainty. They either form rational expectations and internalize the uncertainty about the Central Bank’s preferences in full; or alternatively, and if this process of internalization is costly, it forms a ‘best’ guess regarding those preferences. This implies a certainty equivalence strategy applied to the preference parameters. As those parameters enter the decisions non-linearly, a systematic error emerges. We examine the magnitude of the resulting error in inflation and output, following the assumption of certainty equivalence. Under all reasonable levels of uncertainty this error turns out to be small but involves trading a deflation bias against the cost of gathering the information needed for the full rational expectations solution.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 5042.

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Date of creation: May 2005
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Handle: RePEc:cpr:ceprdp:5042
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  1. Faust, Jon & Svensson, Lars E O, 2002. "The Equilibrium Degree of Transparency and Control in Monetary Policy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 34(2), pages 520-39, May.
  2. Maria Demertzis & Marco Hoeberichts, 2007. "The Costs of Increasing Transparency," Open Economies Review, Springer, vol. 18(3), pages 263-280, July.
  3. Demertzis, Maria & Andrew Hughes Hallett, 2003. "Central Bank Transparency in Theory and Practice," Royal Economic Society Annual Conference 2003 56, Royal Economic Society.
  4. Svensson, Lars E.O. & Faust, John, 1998. "Transparency and Credibility: Monetary Policy with Unobservable Goals," Seminar Papers 636, Stockholm University, Institute for International Economic Studies.
  5. Lucas, Robert Jr., 1972. "Expectations and the neutrality of money," Journal of Economic Theory, Elsevier, vol. 4(2), pages 103-124, April.
  6. Ard Reijer & Peter Vlaar, 2006. "Forecasting Inflation: An Art as Well as a Science!," De Economist, Springer, vol. 154(1), pages 19-40, 03.
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  8. Dieter Gerdesmeier & Barbara Roffia, 2004. "Empirical Estimates of Reaction Functions for the Euro Area," Swiss Journal of Economics and Statistics (SJES), Swiss Society of Economics and Statistics (SSES), vol. 140(I), pages 37-66, March.
  9. Sims, Christopher A., 2003. "Implications of rational inattention," Journal of Monetary Economics, Elsevier, vol. 50(3), pages 665-690, April.
  10. Julio J. Rotemberg & Michael Woodford, 1998. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy: Expanded Version," NBER Technical Working Papers 0233, National Bureau of Economic Research, Inc.
  11. Petra M. Geraats, 2002. "Central Bank Transparency," Economic Journal, Royal Economic Society, vol. 112(483), pages 532-565, November.
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  13. Lucas, Robert E, Jr, 1973. "Some International Evidence on Output-Inflation Tradeoffs," American Economic Review, American Economic Association, vol. 63(3), pages 326-34, June.
  14. Lars Hansen & Thomas Sargent & Thomas Tallarini, . "Robust Permanent Income and Pricing," GSIA Working Papers 1997-51, Carnegie Mellon University, Tepper School of Business.
  15. Hughes Hallett, A. J., 1984. "On alternative methods of generating risk sensitive decision rules," Economics Letters, Elsevier, vol. 16(1-2), pages 37-44.
  16. Muscatelli, Anton, 1998. "Optimal Inflation Contracts and Inflation Targets with Uncertain Central Bank Preferences: Accountability through Independence?," Economic Journal, Royal Economic Society, vol. 108(447), pages 529-42, March.
  17. Kenneth Rogoff, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, Oxford University Press, vol. 100(4), pages 1169-1189.
  18. Cukierman, Alex & Meltzer, Allan H, 1986. "A Theory of Ambiguity, Credibility, and Inflation under Discretion and Asymmetric Information," Econometrica, Econometric Society, vol. 54(5), pages 1099-1128, September.
  19. Hughes Hallett, A. J., 1979. "Computing revealed preferences and limits to the validity of quadratic objective functions for policy optimization," Economics Letters, Elsevier, vol. 2(1), pages 27-32.
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