Expectations, learning and monetary policy: an overview of recent research

Building on Cecchetti and Li (2005), we show that the bank lending channel affects monetary policy trade-offs only when interest rates affect marginal costs of production (ie when there is a cost channel of monetary policy) in the New Keynesian monetary policy model. In our calibrated model the resulting impact of the bank lending channel on output-inflation trade-offs is quantitatively small and of ambiguous sign. When bank capital varies counter cyclically and bank loan rates have a relatively large impact on marginal costs, variation of bank loan margins improves monetary policy trade-offs. The new Basel accord, by increasing capital requirements during economic downturns, offsets this beneficial impact.

Introduction: Expectations about the future are central for determination of current macroeconomic outcomes and the formulation of monetary policy. Recent literature has explored ways for supplementing the benchmark of rational expectations with explicit models of expectations formation that rely on econometric learning. Some apparently natural policy rules turn out to imply expectational instability of private agents’ learning. We use the standard New Keynesian model to illustrate this problem and survey the key results for interest-rate rules that deliver both uniqueness and stability of equilibrium under econometric learning. We then consider some practical concerns such as measurement errors in private expectations, observability of variables and learning of structural parameters required for policy. We also discuss some recent applications, including policy design under perpetual learning, estimated models with learning, recurrent hyperinflation, and macroeconomic policy to combat liquidity traps and deflation.

Author: George W Evans,Seppo Honkapohja

Source: Research Discussion Papers, Bank of Finland

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