Interest Rate Rules and Macroeconomic Stability under Heterogeneous Expectations

46 Pages Posted: 7 May 2009 Last revised: 3 Apr 2012

See all articles by Mikhail Anufriev

Mikhail Anufriev

University of Technology Sydney (UTS)

Tiziana Assenza

Catholic University of Milan; University of Amsterdam - CeNDEF

Cars H. Hommes

University of Amsterdam - Amsterdam School of Economics (ASE); CeNDEF; Tinbergen Institute

Domenico Massaro

Catholic University of Milan; University of Amsterdam - CeNDEF

Date Written: May 7, 2009

Abstract

The recent macroeconomic literature stresses the importance of managing heterogeneous expectations in the formulation of monetary policy. We use a simple frictionless DSGE model to investigate inflation dynamics under alternative interest rate rules when agents have heterogeneous expectations and update their beliefs based on past performance as in Brock and Hommes (1997). The stabilizing effect of different monetary policies depends on the ecology of forecasting rules (i.e., the composition of the set of predictors), on agents' sensitivity to differences in forecasting performance and on how aggressively the monetary authority sets the nominal interest rate in response to inflation. In particular, if the monetary authority only responds weakly to inflation, a cumulative process with rising inflation is likely. On the other hand, a Taylor interest rate rule that sets the interest rate more than point for point in response to inflation stabilizes inflation dynamics, but does not always lead the system to converge to the rational expectations equilibrium as multiple equilibria may persist.

Keywords: Heterogeneous Expectations, Monetary Policy, Cumulative Process, Taylor Rule

JEL Classification: E52, D83, D84, C62

Suggested Citation

Anufriev, Mikhail and Assenza, Tiziana and Hommes, Cars H. and Massaro, Domenico, Interest Rate Rules and Macroeconomic Stability under Heterogeneous Expectations (May 7, 2009). Macroeconomic Dynamics, Forthcoming, Available at SSRN: https://ssrn.com/abstract=1400748 or http://dx.doi.org/10.2139/ssrn.1400748

Mikhail Anufriev (Contact Author)

University of Technology Sydney (UTS) ( email )

P. O. Box 123
Broadway, NSW 2007
Australia

Tiziana Assenza

Catholic University of Milan ( email )

University of Amsterdam - CeNDEF ( email )

Roetersstraat 11
Amsterdam, NL-1018WB
Netherlands

Cars H. Hommes

University of Amsterdam - Amsterdam School of Economics (ASE) ( email )

Center for Nonlinear Dynamics in Economics and Finance
1018 WB Amsterdam
Netherlands
+31 20 525 4246 (Phone)
+31 20 525 4349 (Fax)

CeNDEF ( email )

Roetersstraat 11
Amsterdam, NL-1018WB
Netherlands

HOME PAGE: http://www1.fee.uva.nl/cendef/

Tinbergen Institute ( email )

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

Domenico Massaro

Catholic University of Milan ( email )

Largo Gemelli, 1
Via Necchi 9
Milan, MI 20123
Italy

University of Amsterdam - CeNDEF ( email )

Roetersstraat 11
Amsterdam, 1018 WB
Netherlands

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