The Optimal Monetary Policy Response to Belief Distortions: Model-Free Evidence

Jonathan J Adams () and Symeon Taipliadis ()
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Jonathan J Adams: Department of Economics, University of Florida
Symeon Taipliadis: Department of Economics, University of Florida

No 1016, Working Papers from University of Florida, Department of Economics

Abstract: Some inflation forecast errors are predictable. Economic theory predicts that these belief distortions affect the business cycle. How should monetary policy respond? We investigate this question with a model-free approach using high-frequency monetary policy shocks and a structural VAR method to identify the effects of shocks to belief distortions. Belief distortion shocks are contractionary: if households become overly pessimistic about inflation, then unemployment and deflation follow. Intuitively, the optimal policy response is to ease. This is most effective with short-term rates; we find that a 1 p.p. increase in the belief distortion is optimally offset by a 0.85 p.p. surprise interest rate decrease. Monetary policy targeting longer-term rates is less effective but also useful.

JEL-codes: D84 E30 E52 E70 (search for similar items in EconPapers)
Date: 2025-03
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