Working Paper: CEPR ID: DP3962
Authors: George W. Evans; Seppo Honkapohja
Abstract: We review the recent work on interest rate setting, which emphasizes the desirability of designing policy to ensure stability under learning. Appropriately designed expectations-based rules can yield optimal rational expectations equilibria that are both determinate and stable under learning. Some simple instrument rules and approximate targeting rules also have these desirable properties. We discuss various complications in implementing optimal policy, including the observability of key variables and the required knowledge of structural parameters. An additional issue that we take up concerns the implications of expectation shocks not arising from transitional learning effects.
Keywords: adaptive learning; commitment; determinacy; expectations shocks; interest rate setting; 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 |
|---|---|
| optimal interest rate rules designed to incorporate expectations (E43) | stable rational expectations equilibria (REE) (C62) |
| performance of interest rate rules (E43) | convergence of the economy towards desired REE (F62) |
| certain optimal interest rate policies (E43) | instability under misaligned agents' expectations (D84) |
| introduction of expectation shocks (D84) | complication in implementation of optimal policies (D78) |