Monetary Policy as a Process of Search

Andrew Caplin and John Leahy

American Economic Review, 1996, vol. 86, issue 4, 689-702

Abstract: Monetary policymakers are uncertain about the state of the economy and learn from the economy's reaction to policy. Private agents, however, anticipate any systematic attempt to incorporate this information into future policy. The authors analyze this feedback in the context of a monetary authority's attempt to stimulate an economy in recession. They show that modest stimuli may prove ineffectual. If small reductions in interest rates are unlikely to promote a response, then they may be followed by further cuts. A vicious circle develops in which the expectation that the policy could fail leads investors to delay investment, thereby promoting failure. Copyright 1996 by American Economic Association.

Date: 1996
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