Abstract: This paper investigates the role of imperfect knowledge regarding
the structure of the economy on 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 continuously update their beliefs regarding the
dynamic structure of the economy based on incoming data. The
process of perpetual learning introduces an additional layer of dynamic
interactions 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 becomes
uncoupled from the policy objective and stagflation results, in a
pattern similar to that experienced in the United States during the
1970s. More generally, we show that in the presence of imperfect
knowledge, policy should respond more aggressively to inflation
than under perfect knowledge.
Keywords: Inflation targeting, policy rules, rational expectations, learning, inflation persistence
Full paper (193 KB PDF)
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Last update: June 6, 2002
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