Heterogeneous Information About the Term Structure of Interest Rates, Least-Squares Learning and Optimal Interest Rate Rules for Inflation Targeting

Bank of Finland Research Discussion Paper No. 23/2004

CentER Discussion Paper No. 2004-14

53 Pages Posted: 21 Jun 2004

See all articles by Eric Schaling

Eric Schaling

Rand Afrikaans University - Department of Economics; Bank of England

Sylvester C. W. Eijffinger

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

M. F. Tesfaselassie

Kiel Institute for the World Economy

Date Written: 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: Information, term structure of interest rates, least squares, optimization, inflation, forecasting, learning, rational expectations, Kalman filter

JEL Classification: C53, E43, E52, F33

Suggested Citation

Schaling, Eric and Eijffinger, Sylvester C. W. and Tesfaselassie, Mewael F., Heterogeneous Information About the Term Structure of Interest Rates, Least-Squares Learning and Optimal Interest Rate Rules for Inflation Targeting (2004). Bank of Finland Research Discussion Paper No. 23/2004; CentER Discussion Paper No. 2004-14. Available at SSRN: https://ssrn.com/abstract=556984 or http://dx.doi.org/10.2139/ssrn.556984

Eric Schaling (Contact Author)

Rand Afrikaans University - Department of Economics ( email )

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Bank of England

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Sylvester C. W. Eijffinger

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

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+31 13 466 3042 (Fax)

CESifo (Center for Economic Studies and Ifo Institute)

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Centre for Economic Policy Research (CEPR)

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United Kingdom

Mewael F. Tesfaselassie

Kiel Institute for the World Economy ( email )

P.O. Box 4309
Kiel, Schleswig-Hosltein D-24100
Germany

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