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Monetary Policy and Heterogeneous Expectations

  • William A. Branch
  • George W. Evans

This paper studies the implications for monetary policy of heterogeneous expectations in a New Keynesian model. The assumption of rational expec?tations is replaced with parsimonious forecasting models where agents select between predictors that are underparameterized. In a Misspecification Equilib?rium agents only select the best-performing statistical models. We demonstrate that, even when monetary policy rules satisfy the Taylor principle by adjusting nominal interest rates more than one for one with inflation, there may exist equilibria with Intrinsic Heterogeneity. Under certain conditions, there may exist multiple misspecification equilibria. We show that these findings have im?portant implications for business cycle dynamics and for the design of monetary policy.

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File URL: http://www.st-andrews.ac.uk/economics/CDMA/papers/wp1011.pdf
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Paper provided by Centre for Dynamic Macroeconomic Analysis in its series CDMA Working Paper Series with number 201011.

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Date of creation: 15 Apr 2010
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Handle: RePEc:san:cdmawp:1011
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  1. Thomas J. Sargent, 2008. "Evolution and Intelligent Design," American Economic Review, American Economic Association, vol. 98(1), pages 5-37, March.
  2. James Bullard & Kaushik Mitra, 2002. "Learning about monetary policy rules," Working Papers 2000-001, Federal Reserve Bank of St. Louis.
  3. Ernst Fehr & Jean-Robert Tyran, . "Limited Rationality and Strategic Interaction, The Impact of the Strategic Environment on Nominal Inertia," IEW - Working Papers 130, Institute for Empirical Research in Economics - University of Zurich.
  4. Mark Gertler & Jordi Gali & Richard Clarida, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December.
  5. Mordecai Kurz & Maurizio Motolese, 2007. "Diverse Beliefs and Time Variability of Risk Premia," Discussion Papers 06-044, Stanford Institute for Economic Policy Research.
  6. 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.
  7. Honkapohja, S. & Evans, G.W., 2000. "Expectations and the Stability Problem for Optimal Monetary Policies," University of Helsinki, Department of Economics 481, Department of Economics.
  8. Branch, William A. & Evans, George W., 2006. "Intrinsic heterogeneity in expectation formation," Journal of Economic Theory, Elsevier, vol. 127(1), pages 264-295, March.
  9. Wiliam Branch & George W. Evans, . "Asset Return Dynamics and Learning," University of Oregon Economics Department Working Papers 2006-14, University of Oregon Economics Department.
  10. Christopher A. Sims & Tao Zha, 2005. "Were There Regime Switches in U.S. Monetary Policy?," Working Papers 92, Princeton University, Department of Economics, Center for Economic Policy Studies..
  11. William A. Brock & Cars H. Hommes, 1997. "A Rational Route to Randomness," Econometrica, Econometric Society, vol. 65(5), pages 1059-1096, September.
  12. Kurz, Mordecai, 1994. "On the Structure and Diversity of Rational Beliefs," Economic Theory, Springer, vol. 4(6), pages 877-900, October.
  13. Wieland, Volker & Wolters, Maik H., 2010. "The diversity of forecasts from macroeconomic models of the U.S. economy," CFS Working Paper Series 2010/08, Center for Financial Studies (CFS).
  14. William A. Branch, 2004. "The Theory of Rationally Heterogeneous Expectations: Evidence from Survey Data on Inflation Expectations," Economic Journal, Royal Economic Society, vol. 114(497), pages 592-621, 07.
  15. Branch, William A. & McGough, Bruce, 2009. "A New Keynesian model with heterogeneous expectations," Journal of Economic Dynamics and Control, Elsevier, vol. 33(5), pages 1036-1051, May.
  16. Young, H. Peyton, 2004. "Strategic Learning and its Limits," OUP Catalogue, Oxford University Press, number 9780199269181, March.
  17. William Branch & George W. Evans, 2007. "Model Uncertainty and Endogenous Volatility," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 10(2), pages 207-237, April.
  18. Bennett T. McCallum, 1997. "Issues in the Design of Monetary Policy Rules," NBER Working Papers 6016, National Bureau of Economic Research, Inc.
  19. Kurz, Mordecai & Jin, Hehui & Motolese, Maurizio, 2003. "The role of expectations in economic fluctuations and the efficacy of monetary policy," CFS Working Paper Series 2003/42, Center for Financial Studies (CFS).
  20. William Branch & Bruce McGough, 2011. "Business cycle amplification with heterogeneous expectations," Economic Theory, Springer, vol. 47(2), pages 395-421, June.
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