Long-term debt pricing and monetary policy transmission under imperfect knowledge

Under rational expectations, monetary policy is generally highly effective in stabilizing the economy. Aggregate demand management operates through the expectations hypothesis of the term structure: Anticipated movements in future short-term interest rates control current demand. This paper explores the effects of monetary policy under imperfect knowledge and incomplete markets. In this environment, the expectations hypothesis of the yield curve need not hold, a situation called unanchored financial market expectations. Whether or not financial market expectations are anchored, the private sector’s imperfect knowledge mitigates the efficacy of optimal monetary policy. Under anchored expectations, slow adjustment of interest rate beliefs limits scope to adjust current interest rate policy in response to evolving macroeconomic conditions. Imperfect knowledge represents an additional distortion confronting policy, leading to greater inflation and output volatility relative to rational expectations. Under unanchored expectations, current interest rate policy is divorced from interest rate expectations. This permits aggressive adjustment in current interest rate policy to stabilize inflation and output. However, unanchored expectations are shown to raise significantly the probability of encountering the zero lower bound constraint on nominal interest rates. The longer the average maturity structure of the public debt, the more severe is the constraint.