The influence of learning and price-level targeting on central bank forward guidance

This paper examines how the effectiveness of central bank forward guidance depends on two key channels: the expectations formation process and the monetary policy regime. The results show that rational expectations relative to an adaptive learning rule amplifies the positive benefits a price-level targeting central bank creates for forward guidance. Specifically, forward guidance generates greater amounts of output and inflation under a price-level than inflation targeting monetary policy regime, but rational expectations overstates these positive benefits compared to adaptive learning. The different responses of expectations between rational expectations and adaptive learning to forward guidance are driving this performance gap. Thus, policymakers should consider how expectations are modeled if forward guidance and price-level targeting are implemented in an economy.     

Nonlinearity in monetary policy: A reconsideration of the opportunistic approach to disinflation

The proponents of the ‘opportunistic’ approach to disinflation suggest that, when inflation is close to the target, the central bank should not counteract inflationary pressures. Orphanides and Wilcox (2002) formalize this idea through a simple policy rule that prescribes a nonlinear adjustment to a history-dependent target for inflation. This embodies a regime change in monetary policy, which reacts to inflation only when this is far from the inflation target. Here we study the opportunistic approach in a New-Keynesian model with sizeable nominal and real rigidites in the form of a positive money demand and adjustment costs for investment. We find that the welfare gains delivered by the opportunistic rule arise from the time-varying inflation target, when welfare is measured by a quadratic approximation of household utility. The nonlinear zone of inaction on inflation improves welfare outcomes only when a central bank loss function with the absolute value of the output gap is used, as proposed by Orphanides and Wilcox (2002).     

Is central bank conservatism desirable under learning?

In a New Keynesian model, we consider the delegation problem of the government when the central bank optimally sets discretionary monetary policy taking account of private expectations formed through adaptive learning. Learning gives rise to an incentive for the central bank to accommodate less the effect of inflation expectations and cost-push shocks on inflation and induces thus a deviation from rational expectations equilibrium. However, discretionary monetary policy under learning suffers from an excessively low stabilization bias. To improve the social welfare, the government should appoint a liberal central banker, i.e., set a negative optimal inflation penalty that decreases with the value of learning coefficient. The main conclusions are valid under both constant- and decreasing-gain learning.     

Inflation targeting in a learning economy: An ABM perspective

This paper investigates the performances of an inflation targeting regime in a learning economy framed as an Agent-Based Model (ABM). We keep our ABM as close as possible to the original New Keynesian (NK) model, but we model the individual behaviour of the agents under procedural rationality à la Simon. Accordingly, we assume that their behaviour is guided by simple rules of thumb – or heuristics – while a continuous learning process governs the evolution of those rules. Under these assumptions that also allow the emergence of agents heterogeneity, we analyze the dynamics of the economy without assuming rational expectations, and study the role that a central bank, implementing an inflation targeting regime via a monetary policy rule, can play in the orientation of these dynamics. Consequently, our main goal is to analyse the interplay between the learning mechanisms operating at the individual level and the features and performances of the inflation targeting regime. Our results point to the prime importance of the credibility of central bank's inflation target regarding macroeconomic stabilisation, as well as the beneficial role played by that target as an anchoring device for private inflation expectations. We also establish the potential welfare cost of imperfect public information and contribute to the current debate on optimal monetary policy rules under imperfect common knowledge and uncertainty.     

Labor contracts,informational discrepancies and the role of monetary policy

This paper examines output stabilization and inflationary consequences of short-run monetary policy. The macroeconomic framework incorporates informational discrepancies between the monetary authority and economic agents who form long-term labor contracts. Economic agents are assumed to form rational expectations of the rate of inflation. One result of the analysis is that optimal monetary policy rules for stabilizing fluctuations in output and inflation are independent of the structure of the wage contracts and the degree of informational discrepancy. A second proposition shows that the monetary authority can actually make use of specific knowledge concerning the contract structure to reduce fluctuations in the rate of change in output. In particular, the monetary authority can reduce fluctuations in output below those occurring in a frictionless system by increasing fluctuations in the rate of inflation.     

Financial market imperfections and monetary policy strategy

In a model with imperfect money, credit and reserve markets, we examine if an inflation-targeting central bank applying the funds rate operating procedure to indirectly control market interest rates also needs a monetary aggregate as policy instrument. We show that if private agents use information extracted from money and financial markets to form inflation expectations and if interest rate pass-through is incomplete, the central bank can use a narrow monetary aggregate and the discount interest rate as independent and complementary policy instruments to reinforce the credibility of its announcements and the role of inflation target as a nominal anchor for inflation expectations. This study shows how a monetary policy strategy combining inflation targeting and monetary targeting can be conceived to guarantee macroeconomic stability and the credibility of monetary policy. Friedman's k-percent money growth rule, which can generate dynamic instability, and two alternative stabilizing feedback monetary targeting rules are examined.     

Inflation persistence,inflation expectations,and monetary policy in China

This paper constructs a quarterly series of GDP deflator inflation for China from 1979 to 2009 and tests for a structural break with an unknown change point in the dynamic inflation process. Empirical results suggest a significant structural change in inflation persistence. Employing a counterfactual simulation method, we show that the structural change is primarily attributed to better conduct of monetary policy and the resultant better anchored inflation expectations. This finding implies that the quiescence of inflation in China over the past decade could well be followed by a return to a high inflation era in the absence of a determined effort by the monetary authorities in managing inflation expectations. Therefore, the use of a preemptive monetary policy to anchor inflationary expectations and to keep inflation moderate is warranted in China.     

The reaction of disagreements in inflation expectations to fiscal sentiment obtained from information in official communiqués

Using official communiqués about fiscal policy, we develop a fiscal sentiment indicator, and we verify the reaction of disagreements in inflation expectations to fiscal sentiment. This analysis is relevant to inflation targeting (IT) countries because transparency and communication can influence expectations. The results suggest that a more optimistic fiscal sentiment reduces disagreements in inflation expectations. Estimates show that, for higher disagreements in inflation expectations at 12-month maturity, an optimistic fiscal sentiment can reduce the disagreement more sharply. In turn, the fiscal sentiment effect on the disagreement for the 48-month maturity is stronger the smaller the disagreement is. The results allow us to outline the following policy recommendations. First, an optimistic fiscal environment is important in the task of guiding inflation expectations and reducing inflation uncertainty. Second, fiscal communication is an important tool for the expectations formation process, and therefore it must be carefully managed to help in the task of forward guidance of inflation expectations, being important for the IT regime. Third, both fiscal credibility and monetary policy credibility are important for the expectations formation process, particularly for the reduction of inflation uncertainty, representing aspects that must be preserved in countries that adopt the IT regime.     

Expectations and the Stability Problem for Optimal Monetary Policies

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.     

Targets and lags in a two-equation model of US stabilization

A simple model of activist macroeconomic policy derives a reaction function by assuming that rational governments have performance objectives, but are constrained by the Phillips curve. Although not formally modeled, governments apply a variety of instruments to influence inflation and output, in addition to monetary policy these include fiscal policy, bailouts and exchange rates. Our econometric results are generally consistent with US economic history. One qualification is that governments appear more likely to target growth rates than output gaps. Another inference is that inflation expectations are more likely to be backward than forward looking; a variety of rational expectation models fit the data less well than do simple inertial expectations. We also find that annual data series are more appropriate than quarterly ones for studying these issues.     

What if the Fed had been an inflation nutter?

A structural rational expectations model of US monetary policy is used to make a counterfactual experiment of a strongly inflation averse Federal Reserve Bank. Results for US interest rates, output, and inflation over 1965–1999 are discussed.     

An overhaul of Federal Reserve doctrine: Nominal income and the Great Moderation

The Great Moderation is often characterized by the decline in the variability of output and inflation from earlier periods. While a multitude of explanations for the Great Moderation exist, notable research has focused on the role of monetary policy. Specifically, early evidence suggested that this increased stability is the result of monetary policy that responded much more strongly to realized inflation. Recent evidence casts doubt on this change in monetary policy. An alternative hypothesis is that the change in monetary policy was the result of a change in doctrine; specifically the rejection of the view that inflation was largely a cost-push phenomenon. As a result, this alternative hypothesis suggests that the change in monetary policy beginning in 1979 is reflected in the Federal Reserve’s response to expectations of nominal income growth rather than realized inflation as previously argued. I provide evidence for this hypothesis by estimating the parameters of a monetary policy rule in which policy adjusts to forecasts of nominal GDP for the pre- and post-Volcker eras. Finally, I embed the rule in two dynamic stochastic general equilibrium models with gradual price adjustment to determine whether the overhaul of doctrine can explain the reduction in the volatility of inflation and the output gap.     

ADAPTIVE LEARNING AND MONETARY POLICY IN AN OPEN ECONOMY: LESSONS FROM JAPAN

Abstract. Motivated by Japan's economic experiences in recent decades, we incorporate adaptive learning into an open economy dynamic stochastic general equilibrium model to examine the volatility and welfare impact of alternative monetary policies. Comparing four Taylor‐styled policy rules that reflect Japan's monetary policy debates, we first show that imperfect knowledge and the associated learning process induce higher volatility in the economy and that explicit exchange rate stabilization is unwarranted. Moreover, contrary to results under the rational expectation paradigm, we find that while tight inflation controls raise output volatility, they can improve overall welfare under learning by smoothing inflation fluctuations.     

Competing macro-hypotheses in the United States: A Kalman filtering approach

The empirical validity of alternative views about the short-run determinants of real output growth in the United States is investigated. A nested framework is used to test the macro rational expectations (MRE) hypothesis directly against two competing hypotheses - the neo-Keynesian view that anticipated and unanticpated monetary policy both matter,and Friedman's (1977) proposition that increased inflation uncertainty reduces real output at least temporarily. The unobservable explanatory variables are obtained from time-varying-parameter models of inflation and money growth, which generate forecast errors and their conditional variances consistent with rational expectations under a continuously chaning policy regime. The empirical results strongly support Friedman's view. The MRE hypothesis must be rejected since both anticipated and unanticipated monetary changes matter. The results prove robust across different model specifications and estimation techniques.     

Animal spirits and optimal monetary policy design in the presence of labour market frictions

Using a New Keynesian DSGE model with labour market frictions, we compare outcomes for backward-looking animal spirits expectations with rational expectations after technology and demand shocks. For optimal monetary policy, major differences arise only for technology shocks, and discretionary policy performs better than commitment policy under animal spirits expectations. If Taylor rule parameters are chosen to best replicate optimal monetary policy outcomes, inflation targeting is only appropriate for technology shocks, particularly for large labour frictions, while targeting only economic activity is appropriate for demand shocks. Fault tolerance analysis shows high costs from failing to identify true animal spirits expectations and technology shocks.     

Monetary policy and heterogeneous expectations

This paper studies the implications for monetary policy of heterogeneous expectations in a New Keynesian model. The assumption of rational expectations is replaced with parsimonious forecasting models where agents select between predictors that are underparameterized. In a Misspecification Equilibrium agents only select the best-performing statistical models. We demonstrate that, even when monetary policy rules satisfy the Taylor principle by adjusting nominal interest rates more than one for one with inflation, there may exist equilibria with Intrinsic Heterogeneity. Under certain conditions, there may exist multiple misspecification equilibria. We show that these findings have important implications for business cycle dynamics and for the design of monetary policy.     

Liquidity traps, learning and stagnation

We examine global economic dynamics under learning in a New Keynesian model in which the interest-rate rule is subject to the zero lower bound. Under normal monetary and fiscal policy, the intended steady state is locally but not globally stable. Large pessimistic shocks to expectations can lead to deflationary spirals with falling prices and falling output. To avoid this outcome we recommend augmenting normal policies with aggressive monetary and fiscal policy that guarantee a lower bound on inflation. In contrast, policies geared toward ensuring an output lower bound are insufficient for avoiding deflationary spirals.     

Term structure and forward guidance as instruments of monetary policy

This paper studies a simple monetary model with a Ricardian fiscal policy in which equilibria are indeterminate if monetary policy consists solely of a rule for fixing the short-term interest rate. We introduce explicitly into the model the agents’ expectations of inflation which create the indeterminacy and show that there are two types of policies—a term structure rule or a forward guidance rule for the short rate—which lead to determinacy. The first consists in fixing the interest rates on a family of bonds of different maturities as function of realized inflation; the second consists in fixing the short-term interest rate and the expected values of the short-term interest rate for a sequence of periods into the future as a function of realized inflation. If the monetary authority chooses an inflation process that satisfies conditions derived in the paper and applies one of these rules, it anchors agents’ expectations to this process, in the sense that it is the unique inflation process compatible with equilibrium when the interest rates or expected future values of the short rate are those specified by the term structure or forward guidance rule.     

Nominal uniqueness and money non-neutrality in the limit-price exchange process

We define continuous-time dynamics for exchange economies with fiat money. Traders have locally rational expectations, face a cash-in-advance constraint, and continuously adjust their short-run dominant strategy in a monetary strategic market game involving a double-auction with limit-price orders. Money has a positive value except on optimal rest-points where it becomes a ??veil?? and trade vanishes. Typically, there is a piecewise globally unique trade-and-price curve both in real and in nominal variables. Money is not neutral, either in the short-run or long-run and a localized version of the quantity theory of money holds in the short-run. An optimal money growth rate is derived, which enables monetary trade curves to converge towards Pareto optimal rest-points. Below this growth rate, the economy enters a (sub- optimal) liquidity trap where monetary policy is ineffective; above this threshold inflation rises. Finally, market liquidity, measured through the speed of real trades, can be linked to gains-to-trade, households?? expectations, and the quantity of circulating money.