Optimal Monetary Policy When Agents are Learning.

49 Pages Posted: 4 Feb 2010

See all articles by Krisztina Molnar

Krisztina Molnar

Norwegian School of Economics (NHH) - Department of Economics

Sergio Santoro

Universitat Pompeu Fabra

Multiple version iconThere are 2 versions of this paper

Date Written: March 28, 2007

Abstract

Most studies of optimal monetary policy under learning rely on optimality conditions derived for the case when agents have rational expectations. In this paper, we derive optimal monetary policy in an economy where the Central Bank knows, and makes active use of, the learning algorithm agents follow in forming their expectations. In this setup, monetary policy can influence future expectations through its effect on learning dynamics, introducing an additional trade-off between inflation and output gap stabilization. Specifically, the optimal interest rate rule reacts more aggressively to out of equilibrium inflation expectations and noisy cost-push shocks than would be optimal under rational expectations: the Central Bank exploits its ability to drive" future inflation expectations closer to equilibrium. This optimal policy qualitatively resembles optimal policy when the Central Bank can commit and agents have rational expectations. Moreover, when beliefs are updated according to recursive least squares, the optimal policy is time-varying: after a structural break the Central Bank should be more aggressive and relax the degree of aggressiveness in subsequent periods. The policy recommendation is robust: under our policy the welfare loss if the private sector actually has rational expectations is much smaller than if the Central Bank mistakenly assumes rational expectations whereas in fact agents are learning.

Keywords: Optimal Monetary Policy, Learning, Rational Expectations

JEL Classification: C62, D83, D84, E0, E5

Suggested Citation

Molnar, Krisztina and Santoro, Sergio, Optimal Monetary Policy When Agents are Learning. (March 28, 2007). NHH Dept. of Economics Discussion Paper No. 7/2007, Available at SSRN: https://ssrn.com/abstract=1547894 or http://dx.doi.org/10.2139/ssrn.1547894

Krisztina Molnar (Contact Author)

Norwegian School of Economics (NHH) - Department of Economics ( email )

Helleveien 30
N-5035 Bergen
Norway

Sergio Santoro

Universitat Pompeu Fabra ( email )

Ramon Trias Fargas 25-27
08005 Barcelona
Spain

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