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Learning, expectations formation and the pitfalls of optimal control monetary policy

  • Athanasios Orphanides
  • John C. Williams

This paper examines the robustness characteristics of optimal control policies derived under the assumption of rational expectations to alternative models of expectations. We assume that agents have imperfect knowledge about the precise structure of the economy and form expectations using a forecasting model that they continuously update based on incoming data. We find that the optimal control policy derived under the assumption of rational expectations can perform poorly when expectations deviate modestly from rational expectations. We then show that the optimal control policy can be made more robust by deemphasizing the stabilization of real economic activity and interest rates relative to inflation in the central bank loss function. That is, robustness to learning provides an incentive to employ a "conservative" central banker. We then examine two types of simple monetary policy rules from the literature that have been found to be robust to model misspecification in other contexts. We find that these policies are robust to empirically plausible parameterizations of the learning models and perform about as well or better than optimal control policies.

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Paper provided by Federal Reserve Bank of San Francisco in its series Working Paper Series with number 2008-05.

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Date of creation: 2008
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Handle: RePEc:fip:fedfwp:2008-05
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  1. Athanasios Orphanides & John C. Williams, 2003. "Robust monetary policy rules with unknown natural rates," Finance and Economics Discussion Series 2003-11, Board of Governors of the Federal Reserve System (U.S.).
  2. Svensson, Lars E O & Williams, Noah, 2007. "Monetary Policy with Model Uncertainty: Distribution Forecast Targeting," CEPR Discussion Papers 6331, C.E.P.R. Discussion Papers.
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  5. Kosuke Aoki & Kalin Nikolov, 2004. "Rule-based monetary policy under central bank learning," Bank of England working papers 235, Bank of England.
  6. Andrew Levin & Volker Wieland & John C. Williams, 2001. "The performance of forecast-based monetary policy rules under model uncertainty," Finance and Economics Discussion Series 2001-39, Board of Governors of the Federal Reserve System (U.S.).
  7. Orphanides, Athanasios & Williams, John C., 2007. "Robust monetary policy with imperfect knowledge," Working Paper Series 0764, European Central Bank.
  8. Marcet, Albert & Sargent, Thomas J., 1989. "Convergence of least squares learning mechanisms in self-referential linear stochastic models," Journal of Economic Theory, Elsevier, vol. 48(2), pages 337-368, August.
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  11. Andrew Levin & Volker Wieland & John C. Williams, 1998. "Robustness of simple monetary policy rules under model uncertainty," Finance and Economics Discussion Series 1998-45, Board of Governors of the Federal Reserve System (U.S.).
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  20. Robert J. Tetlow, 2010. "Real-time model uncertainty in the United States: 'Robust' policies put to the test," Finance and Economics Discussion Series 2010-15, Board of Governors of the Federal Reserve System (U.S.).
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  29. Ann-Charlotte Eliasson & Peter Isard & Douglas Laxton, 1999. "Simple Monetary Policy Rules Under Model Uncertainty," IMF Working Papers 99/75, International Monetary Fund.
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