Inflation Targeting and Macroeconomic Stability with Heterogeneous Inflation Expectations

Abstract

Drawing on an extensive empirical literature that suggests persistent and time-varying heterogeneity in inflation expectations, this paper embeds two inflation forecasting heuristics – one based on the current rate of inflation, the second anchored to the official inflation target – in a simple macrodynamic model. Decision makers switch between these forecasting heuristics based on satisficing evolutionary dynamics. We show that convergence towards an equilibrium consistent with the level of output and rate of inflation targeted by policy makers is achieved regardless of whether or not the satisficing evolutionary dynamics that guide the choices agents make between inflation forecasting strategies are subject to noise. We also show that full credulity – a situation where all agents eventually use the forecasting heuristic based on the target rate of inflation – is neither a necessary condition for realization of the inflation target, nor an inevitable consequence of the economy’s achievement of this target. These results demonstrate that uncertainty in decision making resulting in norm-based inflation expectations that are both heterogeneous and time-varying need not thwart the successful conduct of macroeconomic policy.