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INTEREST RATE RULES AND MACROECONOMIC STABILITY UNDER HETEROGENEOUS EXPECTATIONS

Published online by Cambridge University Press:  24 September 2012

Mikhail Anufriev
Affiliation:
University of Technology, Sydney and University of Amsterdam
Tiziana Assenza
Affiliation:
Catholic University of Milan and University of Amsterdam
Cars Hommes
Affiliation:
University of Amsterdam
Domenico Massaro
Affiliation:
University of Amsterdam
Corresponding
E-mail address:

Abstract

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 inflation 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), 1059–1095 (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 agents' sensitivity to differences in forecasting performance, and on how aggressively the monetary authority sets the nominal interest rate in response to inflation. In particular, if the monetary authority responds only weakly to inflation, a cumulative process with rising inflation is likely. On the other hand, a Taylor interest rate rule that sets the interest rate more than point for point in response to inflation stabilizes inflation dynamics, but does not always lead the system to converge to the rational expectations equilibrium, as multiple equilibria may persist.

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Articles
Copyright
Copyright © Cambridge University Press 2012 

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