Working Paper: NBER ID: w24692
Authors: Michael Woodford
Abstract: It is common to analyze the effects of alternative monetary policy commitments under the assumption of fully model-consistent expectations. This implicitly assumes unrealistic cognitive abilities on the part of economic decision makers. The relevant question, however, is not whether the assumption can be literally correct, but how much it would matter to model decision making in a more realistic way. A model is proposed, based on the architecture of artificial intelligence programs for problems such as chess or go, in which decision makers look ahead only a finite distance into the future, and use a value function learned from experience to evaluate situations that may be reached after a finite sequence of actions by themselves and others. Conditions are discussed under which the predictions of a model with finite-horizon forward planning are similar to those of a rational expectations equilibrium, and under which they are instead quite different. The model is used to re-examine the consequences that should be expected from a central-bank commitment to maintain a fixed nominal interest rate for a substantial period of time. “Neo-Fisherian” predictions are shown to depend on using rational expectations equilibrium analysis under circumstances in which it should be expected to be unreliable.
Keywords: Monetary Policy; Bounded Rationality; Finite Planning Horizons
JEL Codes: E03; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| finite-horizon forward planning (D15) | predictions of a rational expectations equilibrium (D84) |
| bounded rationality (D01) | unreliable neo-Fisherian predictions (E19) |
| central bank's commitment to fixed nominal interest rate (E43) | outcomes contingent on agents' planning horizons (D84) |
| boundedly rational approach (D01) | different conclusions than rational expectations models (E19) |