Heterogenous Information About the Term Structure of Interest Rates, Least-Squares Learning and Optimal Interest Rate Rules

37 Pages Posted: 7 Apr 2004

See all articles by Sylvester C. W. Eijffinger

Sylvester C. W. Eijffinger

Tilburg University (CentER) - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute); Centre for Economic Policy Research (CEPR)

Eric Schaling

Rand Afrikaans University - Department of Economics; Bank of England

M. F. Tesfaselassie

affiliation not provided to SSRN

Date Written: March 2004

Abstract

In this Paper, we incorporate the term structure of interest rates in a standard inflation forecast targeting framework. Learning about the transmission process of monetary policy is introduced by having heterogeneous agents - i.e., the central bank and private agents - who have different information sets about the future sequence of short-term interest rates. We analyse inflation forecast targeting in two environments. One in which the central bank has perfect knowledge, in the sense that it understands and observes the process by which private sector interest rate expectations are generated, and one in which the central bank has imperfect knowledge and has to learn the private sector forecasting rule for short-term interest rates. In the case of imperfect knowledge, the central bank has to learn about private sector interest rate expectations, as the latter affect the impact of monetary policy through the expectations theory of the term structure of interest rates. Here following Evans and Honkapohja (2001), the learning scheme we investigate is that of least-squares learning (recursive OLS) using the Kalman filter. We find that optimal monetary policy under learning is a policy that separates estimation and control. Therefore, this model suggests that the practical relevance of the breakdown of the separation principle and the need for experimentation in policy may be limited.

Keywords: Learning, rational expectations, separation principle, Kalman filter, term structure of interest rates

JEL Classification: C53, E43, E52, F33

Suggested Citation

Eijffinger, Sylvester C. W. and Schaling, Eric and tesfaselassie, mewael F., Heterogenous Information About the Term Structure of Interest Rates, Least-Squares Learning and Optimal Interest Rate Rules (March 2004). CEPR Discussion Paper No. 4279. Available at SSRN: https://ssrn.com/abstract=527242

Sylvester C. W. Eijffinger (Contact Author)

Tilburg University (CentER) - Department of Economics ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
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CESifo (Center for Economic Studies and Ifo Institute)

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Germany

HOME PAGE: http://www.CESifo.de

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Eric Schaling

Rand Afrikaans University - Department of Economics ( email )

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South Africa
+27 11 489 2927/7068 (Phone)
+27 11 489 3039 (Fax)

Bank of England

Threadneedle Street
London, EC2R 8AH
United Kingdom

Mewael F. Tesfaselassie

affiliation not provided to SSRN ( email )

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