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Tuesday, December 27, 2005

Robustly Optimal Monetary Policy with Near Rational Expectations

This paper from Michael Woodford investigates the consequences when the relationship between policy announcements and changes in expectations is not as systematic as rational expectations would imply, i.e. if the central bank cannot predict precisely how expectations of the public will react to a policy announcement. Because the policymaker cannot predict the exact response, the best policy is one that is robust to the range of possible "near rational expectations" outcomes. Importantly, such uncertainty does not justify a higher long-run inflation target, does not reduce the value of commitment to a policy target, and makes policy more history dependent. This paper, like most of Woodford's work, is not for the mathematically faint at heart:

Robustly Optimal Monetary Policy with Near Rational Expectations, by Michael Woodford, NBER WP 11896, December 2005 Abstract The paper considers optimal monetary stabilization policy in a forward-looking model, when the central bank recognizes that private-sector expectations need not be precisely model-consistent, and wishes to choose a policy that will be as good as possible in the case of any beliefs that are close enough to model-consistency. ... The main qualitative conclusions of the rational-expectations analysis of optimal policy carry over to the weaker assumption of near-rational expectations. It is found that commitment continues to be important for optimal policy, that the optimal long-run inflation target is unaffected by the degree of potential distortion of beliefs, and that optimal policy is even more history-dependent than if rational expectations are assumed. ... Conclusion ... And, as in the RE analysis, a crucial feature of an optimal commitment is a guarantee that inflation will be low and fairly stable. The fact that private beliefs may be distorted does not provide any reason to aim for a higher average rate of inflation, while it does provide a reason for the central bank to resist even more firmly the inflationary consequences of "cost- push" shocks. [Open link from author web page.]

    Posted by on Tuesday, December 27, 2005 at 10:31 AM in Academic Papers, Economics, Monetary Policy | Permalink  TrackBack (0)  Comments (2)

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