Imperfect Knowledge, Inflation Expectations, and Monetary Policy

41 Pages Posted: 5 Aug 2003 Last revised: 4 Nov 2010

See all articles by Athanasios Orphanides

Athanasios Orphanides

Massachusetts Institute of Technology (MIT) - Sloan School of Management

John C. Williams

Federal Reserve Bank of New York

Multiple version iconThere are 2 versions of this paper

Date Written: August 2003

Abstract

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.

Suggested Citation

Orphanides, Athanasios and Williams, John C., Imperfect Knowledge, Inflation Expectations, and Monetary Policy (August 2003). NBER Working Paper No. w9884. Available at SSRN: https://ssrn.com/abstract=430598

Athanasios Orphanides

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
E62-416
Cambridge, MA 02142
United States

HOME PAGE: http://mitsloan.mit.edu/faculty/detail.php?in_spseqno=54058

John C. Williams (Contact Author)

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States

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