Working Paper: CEPR ID: DP14540
Authors: Paul De Grauwe; Yuemei Ji
Abstract: We show that in a world where agents have limited cognitive abilities and, as a result, are prevented from having rational expectations the answer to this question is negative. We find that in “tranquil periods” when market sentiments (animal spirits) are neutral a forward-looking Taylor rule produces similar results as current-looking Taylor rule in terms of output and inflation volatility. However, when the economy is in a regime of booms and bust produced by extreme values of animal spirits the forward-looking central bank will make many policy errors that have to be corrected afterwards. Thus in a regime of extreme uncertainty the use of a forward Taylor rule reduces the quality of policy-making, leading to greater variability of the output and inflation. It is then better for the central bank to use currently observed output and inflation to set the interest rate. The empirical evidence suggests that central banks are often not forward looking. Our model provides the theoretical justification for this.
Keywords: Taylor Rule; Behavioural Macroeconomics; Animal Spirits
JEL Codes: No JEL codes provided
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| forward-looking Taylor rule (E43) | greater volatility during extreme animal spirits (E32) |
| current-looking Taylor rule (E43) | reduced likelihood of policy errors (D78) |
| forward-looking Taylor rule (E43) | higher forecast errors for central bank (E47) |
| higher forecast errors for central bank (E47) | exacerbated volatility of output gap and inflation (E31) |
| forward-looking Taylor rule (E43) | more extrapolative behavior among private agents (D82) |
| more extrapolative behavior among private agents (D82) | influences dynamics of the economy (F41) |
| tranquil periods (E32) | similar results for forward-looking and current-looking Taylor rules (C54) |