DP2805 Expectations and the Stability Problem for Optimal Monetary Policies

Author(s): George W. Evans , Seppo Honkapohja

Publication Date: April 2001

Keyword(s): Adaptive Learning , Instability , Stability , Private Expectations

JEL(s): D84 , E31 , E52

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP2805.asp

A fundamentals-based monetary policy rule, which would be the optimal monetary policy without commitment when private agents have perfectly rational expectations, is unstable if in fact these agents follow standard adaptive learning rules. This problem can be overcome if private expectations are observed and suitably incorporated into the policy maker's optimal rule. These strong results extend to the case in which there is simultaneous learning by the policy maker and the private agents. Our findings show the importance of conditioning policy appropriately, not just on fundamentals, but also directly on observed household and firm expectations.