The Role of Expectations in Economic Fluctuations and the Efficacy of Monetary Policy

We show diversity of beliefs is an important propagation mechanism of fluctuations, money non neutrality and the efficacy of monetary policy. In a competitive model with flexible prices in which agents hold Rational Belief (see Kurz (1994)) we show: (i) Our economy replicates well the empirical record of fluctuations in the U.S. (ii) Under a simple monetary rule without discretion, aggressive anti-inflationary rule can bring inflation volatility down to zero. Stabilization instrument can reduce consumption volatility by some 55% at substantial cost of inflation volatility. To avoid total instability, inflation and output stabilization instruments must be used together. (iii) The Phillips Curve changes substantially with policy instruments. Activist monetary policy eliminates the Phillips Curve and renders it vertical. (iv) Although prices are flexible, money shocks result in less than a proportional changes in inflation hence the aggregate price level appears "sticky" with respect to money shocks. (v) Discretion in monetary policy has an impact on the efficacy of policy depending upon the revision of beliefs induced by central bank discretionary decisions. We study two rationalizable economies. In one market beliefs weaken the effect of policy, discretion has a harmful effect on policy outcomes thus an optimal policy should avoid discretion. In the second, beliefs bolster policy outcomes and discretion is a desirable attribute of the policy rule. Some evidence suggests the structure of market beliefs is closer to the first type, hence avoiding discretion is an optimal central bank policy. (vi) An implication of our model suggests that the current effective policy is not activist and aims mostly to target inflation only.