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Optimal Monetary Policy when Agents are Learning

  • Krisztina Molnar

    ()

    (NHH, UPF)

  • Sergio Santoro

    (UPF)

Most studies of optimal monetary policy under learning rely on optimality conditions derived for the case when agents have rational expectations. In this paper, we derive optimal monetary policy in an economy where the Central Bank knows, and makes active use of, the learning algorithm agents follow in forming their expectations. In this setup, monetary policy can influence future expectations through its effect on learning dynamics, introducing an additional tradeoff between inflation and output gap stabilization. Specifically, the optimal interest rate rule reacts more aggressively to out-of-equilibrium inflation expectations and noisy cost-push shocks than would be optimal under rational expectations: the Central Bank exploits its ability to â€drive†future expectations closer to equilibrium. This optimal policy closely resembles optimal policy when the Central Bank can commit and agents have rational expectations. Monetary policy should be more aggressive in containing inflationary expectations when private agents pay more attention to recent data. In particular, when beliefs are updated according to recursive least squares, the optimal policy is time-varying: after a structural break the Central Bank should be more aggressive and relax the degree of aggressiveness in subsequent periods.

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Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2006 with number 40.

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Date of creation: 04 Jul 2006
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Handle: RePEc:sce:scecfa:40
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