Working Paper: CEPR ID: DP6640
Authors: George W. Evans; Seppo Honkapohja
Abstract: Expectations about the future are central for determination of current macroeconomic outcomes and the formulation of monetary policy. Recent literature has explored ways for supplementing the benchmark of rational expectations with explicit models of expectations formation that rely on econometric learning. Some apparently natural policy rules turn out to imply expectational instability of private agents' learning. We use the standard New Keynesian model to illustrate this problem and survey the key results about interest-rate rules that deliver both uniqueness and stability of equilibrium under econometric learning. We then consider some practical concerns such as measurement errors in private expectations, observability of variables and learning of structural parameters required for policy. We also discuss some recent applications including policy design under perpetual learning, estimated models with learning, recurrent hyperinflations, and macroeconomic policy to combat liquidity traps and deflation.
Keywords: Determinacy; Fluctuations; Imperfect Knowledge; Interest-Rate Setting; Learning; 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 |
|---|---|
| expectations (D84) | macroeconomic outcomes (E66) |
| interest rate rules (E43) | expectational instability (D84) |
| misalignments in expectations (D84) | destabilization of the economy (F65) |
| nonoptimal instrument rules (C36) | forecasting errors (C53) |
| forecasting errors (C53) | undermining stability (C62) |
| optimal interest rate setting (E43) | learnability constraints of agents (D80) |
| learning processes (C45) | challenges for policymakers (D72) |
| design of interest rate rules (E43) | stability (C62) |
| certain interest rate rules (E43) | multiple equilibria (D50) |
| certain interest rate rules (E43) | potential indeterminacy (D89) |