Interest rate rules and macroeconomic stability under heterogeneous expectations

Cambridge University Press
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Journal Article
Macroeconomic Dynamics, 2013, 17 (8), pp. 1574 - 1604
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The recent macroeconomic literature stresses the importance of managing heterogeneous expectations in the formulation of monetary policy. We use a simple frictionless dynamic stochastic general equilibrium (DSGE) model to investigate in?ation dynamics under alternative interest rate rules when agents have heterogeneous expectations, and update their beliefs based on past performance, as in Brock and Hommes [Econometrica 65(5), 1059ï½1095 (1997)]. The stabilizing effect of different monetary policies depends on the ecology of forecasting rules (i.e., the composition of the set of predictors), on agentsï½ sensitivity to differences in forecasting performance, and on how aggressively the monetary authority sets the nominal interest rate in response to in?ation. In particular, if the monetary authority responds only weakly to in?ation, a cumulative process with rising in?ation is likely. On the other hand, a Taylor interest rate rule that sets the interest rate more than point for point in response to in?ation stabilizes in?ation dynamics, but does not always lead the system to converge to the rational expectations equilibrium, as multiple equilibria may persist
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