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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, 2007. "Inflation Targeting under Imperfect Knowledge," Central Banking, Analysis, and Economic Policies Book Series, in: Frederic S. Miskin & Klaus Schmidt-Hebbel & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Se (ed.), Monetary Policy under Inflation Targeting, edition 1, volume 11, chapter 4, pages 077-123 Central Bank of Chile.
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  7. Orphanides, Athanasios & Williams, John C., 2007. "Robust monetary policy with imperfect knowledge," Working Paper Series 0764, European Central Bank.
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  24. Thomas J Sargent, 2007. "Evolution and Intelligent Design," Levine's Bibliography 122247000000001821, UCLA Department of Economics.
  25. Peter Isard & Douglas Laxton & Ann-Charlotte Eliasson, 1999. "Simple Monetary Policy Rules Under Model Uncertainty," International Tax and Public Finance, Springer, vol. 6(4), pages 537-577, November.
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  27. Dean Croushore, 1993. "Introducing: the survey of professional forecasters," Business Review, Federal Reserve Bank of Philadelphia, issue Nov, pages 3-15.
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