Working Paper: CEPR ID: DP2805
Authors: Georges W. Evans; Seppo Honkapohja
Abstract: A fundamentals-based monetary policy rule, which would be the optimal monetary policy without commitment when private agents have perfectly rational expectations, is unstable if in fact these agents follow standard adaptive learning rules. This problem can be overcome if private expectations are observed and suitably incorporated into the policy maker's optimal rule. These strong results extend to the case in which there is simultaneous learning by the policy maker and the private agents. Our findings show the importance of conditioning policy appropriately, not just on fundamentals, but also directly on observed household and firm expectations.
Keywords: adaptive learning; instability; private expectations; stability
JEL Codes: D84; E31; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| fundamentals-based monetary policy rule (E52) | economic instability (E32) |
| private agents following adaptive learning rules (C73) | instability of monetary policy (E63) |
| expectational errors by private agents (D84) | deviation from rational expectations equilibrium (REE) (D84) |
| incorporating private expectations into monetary policy rules (E61) | economic stability (E63) |
| suitably designed monetary policy rule considering private sector expectations (E61) | convergence towards REE (Q30) |
| policymaker learning true structural parameters (C51) | optimal monetary policy (E63) |
| design of monetary policy rules (E61) | economic stability (E63) |