THE ROLE OF MONETARY STABILIZATION POLICY UNDER RATIONAL EXPECTATIONS (original) (raw)

Monetary instruments and policy rules in a rational expectations environment

Journal of Monetary Economics, 1983

This paper explores the implications of rational expectations and the aggregate supply theory advanced by Lucas (1973) for analysis of optimal monetary policy under uncertainty along the lines of Poole (1970), returning to a topic initially treated by Sargent and Wallace (1975). Not surprisingly, these two "classical" concepts alter both the menu of feasible policy choice and the desirability of certain policy actions. In our setup, unlike that of Sargent and Wallace (1975), the systematic component of monetary policy is a relevant determinant of the magnitude of "business fluctuations" that arise from shocks to the system. Central bank behavior-both the selection of monetary instruments and the framing of overall policy respJnse to economic conditions-can work to diminish or increase the magnitude of busir.ss fluctuations. However, the "activist" policies stressed by the present discussion bear little (if any) relationship to the policy options rationalized by' the conventional analysis of monetary policy under uncertainty. In particular, in contrast to Poole's analysis, money supply responses to the nominal interest rate are not important determinants of real economic activity. Rather, the central bank should focus on policies that make movements in the general price level readily identifiable by economic agents.

Monetary policy and the transition to rational expectations

2004

Under the assumption of bounded rationality, economic agents learn from their past mistaken predictions by combining new and old information to form new beliefs. The purpose of this paper is to examine how the policy maker, by affecting the private agents' ...

Monetary, financial and fiscal policy under rational expectations

International Monetary Fund Staff Papers 27, Dec. 1980, 758-813., 1980

The implications for the effectiveness of monetary, fiscal and financial policy of the "rational expectations revolution" are evaluated. The general conclusion is that to anticipate policy is not to neutralize it. This is obviously the case for structural policies that alter the level and composition of full employment output. It also holds for stabilization policies that influence deviations of real variables from their "natural" values. Substitution of bond financing for tax financing of a given real spending program reduces saving and lowers the capital-labor ratio, even when allowance is made for private intergenerational gifts. Anticipated monetary policy affects the cyclical and equilibrium behavior of real variables except in implausible special cases.

Monetary Policy in a Model with Misspecified, Heterogeneous and Ever-Changing Expectations

SSRN Electronic Journal, 2000

The applied literature on adaptive learning has mostly focused on small, linear models, where the minimum state variable (MSV) solution of the rational expectations equilibrium is used as the agents'perceived law of motion (PLM). In nonlinear models a closed-form MSV solution does not exist and if the model is medium or large-sized there is no univocal linear approximation that is eligible as a candidate PLM. Accordingly, heterogeneous expectations prevail and the process through which agents select (and change) a forecasting model becomes a necessary ingredient of the analysis; moreover, the temporary equilibrium of the learning process no longer converges to the REE, but rather approaches an asymptotic limit that depends on the speci…c form of the expectations equations and hence may be a¤ected by the communication strategies of the monetary policymaker. The objective of this paper is to assess whether in such a model economy, where expectations are mis-speci…ed, heterogeneous and ever changing, the optimal monetary policy exhibits properties that are similar to those found in the literature for small, linear models (e.g. Orphanides and Williams 2007). The main results are the following: (1) expectations heterogeneity is an intrinsic feature of the economy: no PLM succeeds in ruling out all the other forecasting models, though the most inaccurate ones are eventually dismissed; (2) contrary to previous …ndings, the monetary policymaker has no incentive to adopt more in ‡ation-averse policies to keep expectations anchored to targets: too strong a reaction to price shocks increases both in ‡ation and output volatility and tends to make the model unstable and non-learnable; (3) partial transparency seem to enhance somewhat welfare (but fully transparent policies do not), by reducing the slope of the term structure and the variability of long-term interest rates. A higher degree of transparency calls for stronger in ‡ation aversion, so partially recovering the …ndings by Orphanides and Williams.

The Role of Expectations in Monetary Policy

International Finance, 2006

Recent literature on monetary policy has emphasised the role of expectations and the merits of tying them down through credible commitment. However, although always in favour of reaping the bene…ts of having committed, Central Banks worry about the fact that in real time, it is not always easy to assume that they are in such a position. Decisions need to be taken then, under the assumption of predetermined expectations. We argue that in these circumstances, the provision of clear in ‡ation objectives helps agents understand Central Bank objectives better and is thus bene…cial to all.

Rational expectations and the theory of economic policy

Journal of Monetary Economics, 1976

There is no longer any serious debate about whether monetary policy should be conducted according to rules or discretion. Quite appropriately, it is widely agreed that monetary policy should obey a rule, that is, a schedule expressing the setting of the monetary authority's instrument (e.g. the money supply) as a function of all the information it has received up through the current moment. Such a rule has the happy characteristic that in any given set of circumstances, the optimal setting for policy is unique. If by remote chance, the same circumstances should prevail at two different dates, the appropriate settings for monetary policy would be identical.

The role of expectations in economic fluctuations and the efficacy of monetary policy

Journal of Economic Dynamics and Control, 2005

This paper investigates the role that imperfect knowledge about the structure of the economy plays in the formation of expectations, macroeconomic dynamics, and the efficient formulation of monetary policy. Economic agents rely on an adaptive learning technology to form expectations and to update continuously their beliefs regarding the dynamic structure of the economy based on incoming data. The process of perpetual learning introduces an additional layer of dynamic interaction between monetary policy and economic outcomes. We find that policies that would be efficient under rational expectations can perform poorly when knowledge is imperfect. In particular, policies that fail to maintain tight control over inflation are prone to episodes in which the public's expectations of inflation become uncoupled from the policy objective and stagflation results, in a pattern similar to that experienced in the United States during the 1970s. Our results highlight the value of effective communication of a central bank's inflation objective and of continued vigilance against inflation in anchoring inflation expectations and fostering macroeconomic stability.