Aggressive Monetary Policy and Inflation Persistence: An Adaptive Learning Approach

Abstract:     
We investigate the effectiveness of an aggressive anti-inflation monetary policy on the ability of agents to achieve rational expectations equilibrium (REE) forecasts of inflation. An aggressive anti-inflation policy includes a willingness to respond more forcefully to deviations from an inflation target. Using an adaptive learning framework, we develop a model that uses a real contracting rigidity in conjunction with an interest rate rule and an IS curve. The model equilibrium indicates that only an aggressive anti-inflation policy enables agents to learn the REE inflation forecast. The model also shows that inflation persistence (volatility) has a negative relation with policy aggressiveness. Empirical tests confirm this negative relation but these tests also indicate there is a lag between aggressive policy shifts and effective changes in inflation persistence (volatility).

Number of Pages in PDF File: 51

Keywords: Taylor Rule, Taylor Principle, real wage contract, interest rate rule, aggressive monetary policy, adaptive learning, stability, determinacy, inflation persistence

JEL Classification: E4, E5, E31, E52, D84

working papers series