Ambition versus Gradualism in Disinflation Horizons under Bounded Rationality: The Case of Chile

Ali Al-Eyd ()

No 308, National Institute of Economic and Social Research (NIESR) Discussion Papers from National Institute of Economic and Social Research

Abstract: This paper uses a stylized New Keynesian Model to examine alternative disinflation strategies under optimal monetary policy conditions with bounded rationality. The model is calibrated for Chile and presents some policy tradeoffs not necessarily captured under the full rational expectations solution. Under rational expectations and in the absence of nominal inertia, the optimal policy suggests an ambitious disinflation horizon as expectations of inflation are revised immediately. However, under full adaptive learning, a distinct policy trade-off emerges between ambition and gradualism. We also find that when expectations exhibit a degree of imperfect knowledge it is optimal to increase the strength of the policy response relative to that of the perfect knowledge solution.

Date: 2008-02
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