Learning about Monetary Policy Rules when Long-Horizon Expectations Matter

Bruce Preston
Working Paper 2003-18
October 2003

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This paper considers the implications of an important source of model misspecification for the design of monetary policy rules: the assumed manner of expectations formation. Following a considerable literature on learning, it is assumed that private agents seek to maximize their objectives subject to standard constraints and the restriction of using an econometric model to make inferences about future uncertainty. Agents do not know other agents’ tastes or beliefs and therefore do not have a complete economic model with which to derive true probability laws. Because agents solve a multi-period decision problem, their actions depend on forecasts of macroeconomic conditions many periods into the future, unlike the analysis of the Bullard and Mitra (2002) and Evans and Honkapohja (2002). The central question addressed is whether the learning dynamics converge to the equilibrium predicted by rational expectations equilibrium analysis. This question is considered for several prominent instrument rules for the determination of the nominal interest rate. A key result is that a Taylor rule ensures convergence to rational expectations equilibrium, if the so-called Taylor principle is satisfied, under any of a broad class of specifications of the learning dynamics. This suggests the Taylor rule to be desirable from the point of view of eliminating instability due to self-fulfilling expectations. A companion paper, Preston (2002b), demonstrates that several policy rules argued to be desirable in the recent literature on monetary policy and learning frequently lead to the propagation of self-fulfilling expectations and hence economic instability.

JEL classification: E52, D83, D84

Keywords: adaptive learning, expectations and optimal monetary policy

The author thanks Gauti Eggertsson, Pierre-Olivier Gourinchas, Seppo Honkapohja, Christian Julliard, Guido Lorenzoni, Kaushik Mitra, Chris Sims, Lars Svensson, Andrea Tambalotti, Lawrence Uren, Noah Williams, and especially Jonathan Parker and Mike Woodford for helpful discussions and comments and also seminar participants at the Federal Reserve Bank of Atlanta conference on Monetary Policy and Learning, Board of Governers, Boston Federal Reserve, Columbia University, Harvard University, New York Federal Reserve, University of Maryland, Princeton University, Stanford GSB, 2002 NBER Summer Institute for Monetary Economics. The usual caveat applies. Financial support from the Fellowship of Woodrow Wilson Scholars and use of the resources of the Bendheim Center for Finance are gratefully acknowledged. Revisions available online at: http://www.princeton.edu/~bpreston. Comments welcome at bpreston@princeton.edu. This paper was presented at the Monetary Policy and Learning Conference sponsored by the Federal Reserve Bank of Atlanta in March 2003. The views expressed here are the author’s and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the author’s responsibility.

Please address questions regarding content to Bruce Preston, Department of Economics, Fisher Hall, Princeton University, Princeton, New Jersey 08544, 609-258-4000, bpreston@princeton.edu.