Monetary Policy with Diverse Private Expectations
We study the impact of diverse beliefs on conduct of
monetary policy. Individual belief is modeled by
a state variable that defines an individual’s perceived
laws of motion. We use a New Keynesian Model that is
solved with a quadratic approximation hence individual decisions are quadratic functions. Aggregation renders the
belief distribution an aggregate state variable. Although
the model has standard technology and policy shocks,
diverse expectations change materially standard results
about a smooth trade-off between inflation volatility and
output volatility. Our main results are summed up as follows:
The policy space contains a curve of singularity which is
a collection of policy parameters that divides the space
into two sub-regions. Some trade-off between output and
inflation volatilities exists within each region and some
The singularity causes volatility of variables to be non monotone in policy parameters. Policy-makers cannot assume a more aggressive policy will
change outcomes in a predictable manner.
are diverse a central bank must also consider the volatility
of individual consumption and the related volatility of
financial markets. We show aggressive anti-inflation
policy increases consumption volatility and aggressive output
stabilization policy entails rising inflation volatility. Efficient central bank policy must therefore be moderate.
High optimism about the future typically lowers aggregate output and increases inflation. This “stagflation”
effect is stronger the stickier prices are. Policy response
is muted since the effects of higher inflation and lower
output on interest rates partially cancel each other. Effective policy requires targeting exuberance directly or its
effects in asset markets. Central banks already do so with short term interventions.
The observed high serial
correlation of 0.80 in policy shocks contributes greatly to market volatility and we show that a reduction in
persistence of central bank’s deviations from
a fixed rule will contribute to stability.
Belief dispersion is
measured by cross sectional standard deviation of individual
beliefs. An increased belief diversity is found to make
policy coordination harder and results in lower aggregate
output and lower rate of inflation. Bank policy can
lower belief dispersion by being more transparent.