Optimal Monetary Policy When Agents Are Learning

Krisztina Molnár and Sergio Santoro

No 601, CERS-IE WORKING PAPERS from Institute of Economics, Centre for Economic and Regional Studies

Abstract: Most studies of optimal monetary policy under learning rely on optimality conditions derived for the case when agents have rational expectations. In this paper, we derive optimal monetary policy in an economy where the Central Bank knows, and makes active use of, the learning algorithm agents follow in forming their expectations. In this setup, monetary policy can influence future expectations through its e ect on learning dynamics, introducing an additional tradeo between inflation and output gap stabilization. Specifically, the optimal interest rate rule reacts more aggressively to out-of-equilibrium inflation expectations and noisy cost-push shocks than would be optimal under rational expectations: the Central Bank exploits its ability to "drive" future expectations closer to equilibrium. This optimal policy closely resembles optimal policy when the Central Bank can commit and agents have rational expectations. Monetary policy should be more aggressive in containing inflationary expectations when private agents pay more attention to recent data. In particular, when beliefs are updated according to recursive least squares, the optimal policy is time-varying: after a structural break the Central Bank should be more aggressive and relax the degree of aggressiveness in subsequent periods. The policy recommendation is robust: under our policy the welfare loss if the private sector actually has rational expectations is much smaller than if the Central Bank mistakenly assumes rational expectations whereas in fact agents are learning.

Keywords: Optimal Monetary Policy; Learning; Rational Expectations (search for similar items in EconPapers)
JEL-codes: C62 D83 D84 E0 E5 (search for similar items in EconPapers)
Date: 2006-03-15, Revised 2006-03-15
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
References: View complete reference list from CitEc
Citations: View citations in EconPapers (23)

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Related works:
Journal Article: Optimal monetary policy when agents are learning (2014)
Working Paper: Optimal Monetary Policy When Agents Are Learning (2010)
Working Paper: Optimal Monetary Policy when Agents are Learning (2010)
Working Paper: Optimal Monetary Policy When Agents Are Learning (2008)
Working Paper: Optimal Monetary Policy when Agents are Learning (2006)
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Persistent link: https://EconPapers.repec.org/RePEc:has:discpr:0601

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