Forming Rational Expectations and When it is Right to Be 'Wrong'

16 Pages Posted: 15 Sep 2005

See all articles by Maria Demertzis

Maria Demertzis

Bruegel

Andrew J. Hughes

Cardiff Business School; Centre for Economic Policy Research (CEPR); Vanderbilt University - College of Arts and Science - Department of Economics

Date Written: May 2005

Abstract

In this paper, we examine the effects of private agents being less than fully rational. We examine this in the context of monetary policy, where the Central Bank may have uncertain preferences either by choice or by necessity. The new feature is that we allow the public to react in two different ways to this uncertainty. They either form rational expectations and internalize the uncertainty about the Central Bank's preferences in full; or alternatively, and if this process of internalization is costly, it forms a 'best' guess regarding those preferences. This implies a certainty equivalence strategy applied to the preference parameters. As those parameters enter the decisions non-linearly, a systematic error emerges. We examine the magnitude of the resulting error in inflation and output, following the assumption of certainty equivalence. Under all reasonable levels of uncertainty, this error turns out to be small but involves trading a deflation bias against the cost of gathering the information needed for the full rational expectations solution.

Keywords: Central bank preference uncertainty, certainty equivalence, rational expectations

JEL Classification: E52, E58

Suggested Citation

Demertzis, Maria and Hughes Hallett, Andrew J., Forming Rational Expectations and When it is Right to Be 'Wrong' (May 2005). CEPR Discussion Paper No. 5042. Available at SSRN: https://ssrn.com/abstract=774224

Maria Demertzis

Bruegel ( email )

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Andrew J. Hughes Hallett (Contact Author)

Cardiff Business School ( email )

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Centre for Economic Policy Research (CEPR)

London
United Kingdom

Vanderbilt University - College of Arts and Science - Department of Economics ( email )

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Nashville, TN 37235
United States
615-322-8539 (Phone)
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