Bounded Rationality, Monetary Policy, and Macroeconomic Stability

11 Pages Posted: 14 Jul 2019 Last revised: 18 Nov 2021

See all articles by Francisco Ilabaca

Francisco Ilabaca

University of California, Irvine - Department of Economics

Greta Meggiorini

University of California, Irvine - Department of Economics

Fabio Milani

University of California, Irvine - Department of Economics

Date Written: 2019

Abstract

This paper estimates a Behavioral New Keynesian model to revisit the evidence that passive US monetary policy in the pre-1979 sample led to indeterminate equilibria and sunspot-driven fluctuations, while active policy after 1982, by satisfying the Taylor principle, was instrumental in restoring macroeconomic stability. The model assumes “cognitive discounting�, i.e., consumers and firms pay less attention to variables further into the future. We estimate the model allowing for both determinacy and indeterminacy. The empirical results show that determinacy is preferred both before and after 1979. Even if monetary policy is found to react only mildly to inflation pre-Volcker, the substantial degrees of bounded rationality that we estimate prevent the economy from falling into indeterminacy.

Keywords: Behavioral New Keynesian model, cognitive discounting, estimation under determinacy and indeterminacy, Taylor principle, active vs passive monetary policy

JEL Classification: E310, E320, E520, E580, E700

Suggested Citation

Ilabaca, Francisco and Meggiorini, Greta and Milani, Fabio, Bounded Rationality, Monetary Policy, and Macroeconomic Stability (2019). CESifo Working Paper No. 7706, Available at SSRN: https://ssrn.com/abstract=3418630 or http://dx.doi.org/10.2139/ssrn.3418630

Francisco Ilabaca (Contact Author)

University of California, Irvine - Department of Economics ( email )

3151 Social Science Plaza
Irvine, CA 92697-5100
United States

Greta Meggiorini

University of California, Irvine - Department of Economics ( email )

3151 Social Science Plaza
Irvine, CA 92697-5100
United States

Fabio Milani

University of California, Irvine - Department of Economics ( email )

3151 Social Science Plaza
Irvine, CA 92697-5100
United States

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