Abstract
This paper examines optimal monetary policy under heterogeneous expectations. To this end, we develop a stochastic New Keynesian model with a cost-push shock and coexistence of one-step-ahead rational and adaptive expectations in decentralized markets. On the one side, heterogeneous expectations imply an amplification mechanism that has many adverse consequences missing under the rational expectations paradigm. On the other side, even discretionary optimal monetary policy can manipulate expectations via a novel channel. We argue that the incorporation of heterogeneous expectations in both the design and implementation of discretionary optimal monetary policy to exploit this channel lowers macroeconomic volatility. We find that: (1.) a more hawkish policy can reduce losses due to volatility, but an overly hawkish policy does not; (2.) overestimating the share of rational expectations in the design and implementation of policy creates additional losses, while the underestimation does not; (3.) credible commitment eliminates or mitigates many of the ramifications of heterogeneous expectations.
Highlights
Leading central bankers conclude that the New Keynesian inflation targeting framework developed in the last decades has been an effective tool for macroeconomic stabilization policy before and throughout the Great Recession
Our main results can be summarized as follows: (i) without commitment, determinacy can only be obtained in part of the structural parameter space; (ii) relative to the rational expectations hypothesis (REH) benchmark, the amplification mechanism under heterogeneous expectations increases central bank losses due to aggregate shocks irrespective of the particular policy; (iii) the inflation variability trade-off moves outward in a non-monotonic manner with the share of adaptive expectations (AE); (iv) the higher the central bank’s preference for output stabilization the larger the losses for the central bank; (v) commitment is less effective under heterogeneous expectations than under the rational expectations (RE) benchmark, but still, many of the potential hazards of heterogeneous expectations can be either eliminated or mitigated, and, most surprisingly, determinacy is guaranteed throughout the structural parameter space among all calibrations
For optimal monetary policy with commitment from a timeless perspective under heterogeneous expectations, implemented via expectations-based reaction function (39), we find that: 2.1 the model is determinate throughout the parameter space; 2.2 Losses are strictly higher compared to the REH benchmark, but strictly lower compared to the case of discretion; 2.3 The inflation output variability trade-off shifts out in non-monotonic way, depending on the share of AE; 2.4 A higher preference for output stabilization, ωx, implies higher losses
Summary
Leading central bankers conclude that the New Keynesian inflation targeting framework developed in the last decades has been an effective tool for macroeconomic stabilization policy before and throughout the Great Recession. One reason often mentioned is that the framework provides guidance on how to manage expectations, which appears to be crucial for stabilization policy. We are grateful to the Economic Institute of the Narodowy Bank Polski and the University of California, Irvine for outstanding hospitality during the time as visiting researcher while working on this project. Financial support from Fundação para a Ciência e a Tecnologia (UIDB/00315/2020), the Berlin Economics Research Associates (BERA) program, the Fritz Thyssen Foundation (50.17.0.004WW) and the Austrian National Bank
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