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The Optimal Monetary Policy Response to Belief Distortions: Model-Free Evidence

Author

Listed:
  • Jonathan J Adams

    (Department of Economics, University of Florida)

  • Symeon Taipliadis

    (Department of Economics, University of Florida)

Abstract

Some inflation forecast errors are predictable. Economic theory predicts that these belief distortions affect the business cycle. How should monetary policy respond? We investigate this question with a model-free approach using high-frequency monetary policy shocks and a structural VAR method to identify the effects of shocks to belief distortions. Belief distortion shocks are contractionary: if households become overly pessimistic about inflation, then unemployment and deflation follow. Intuitively, the optimal policy response is to ease. This is most effective with short-term rates; we find that a 1 p.p. increase in the belief distortion is optimally offset by a 0.85 p.p. surprise interest rate decrease. Monetary policy targeting longer-term rates is less effective but also useful.

Suggested Citation

  • Jonathan J Adams & Symeon Taipliadis, 2025. "The Optimal Monetary Policy Response to Belief Distortions: Model-Free Evidence," Working Papers 001016, University of Florida, Department of Economics.
    • Handle: RePEc:ufl:wpaper:001016
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    References listed on IDEAS

    as
    1. James H. Stock & Mark W. Watson, 2018. "Identification and Estimation of Dynamic Causal Effects in Macroeconomics Using External Instruments," Economic Journal, Royal Economic Society, vol. 128(610), pages 917-948, May.
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    More about this item

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • E70 - Macroeconomics and Monetary Economics - - Macro-Based Behavioral Economics - - - General

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