Imperfect Knowledge, Inflation Expectations, and Monetary Policy

Athanasios Orphanides and John C. Williams

in The Inflation-Targeting Debate

Published by University of Chicago Press

Published in print February 2005 | ISBN: 9780226044712
Published online February 2013 | e-ISBN: 9780226044736 | DOI:
Imperfect Knowledge, Inflation Expectations, and Monetary Policy

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Rational expectations provide an elegant and powerful framework that has come to dominate thinking about the dynamic structure of the economy and econometric policy evaluation over the past thirty years. Researchers have proposed refinements to rational expectations that respect the principle that agents use information efficiently in forming expectations, but nonetheless recognize the limits to and costs of information processing and cognitive constraints that influence the expectations-formation process. This chapter considers a form of imperfect knowledge in which economic agents rely on an adaptive learning technology to form expectations. It shows that the resulting process of perpetual learning introduces an additional layer of interaction between monetary policy and economic outcomes that has important implications for macroeconomic dynamics and for monetary policy design. It also demonstrates that monetary policies that would be efficient under rational expectations can perform poorly when knowledge is imperfect. The chapter describes a stylized model that gives rise to a non-trivial trade-off between inflation and output variability and in which a simple one-parameter policy rule represents optimal monetary policy under rational expectations.

Keywords: imperfect knowledge; inflation expectations; monetary policy; rational expectations; perpetual learning; inflation; output variability

Chapter.  16691 words.  Illustrated.

Subjects: Financial Markets

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