Abstract
This paper studies the implications for monetary policy of heterogeneous expectations in a New Keynesian model. The assumption of rational expectations is replaced with parsimonious forecasting models where agents select between predictors that are underparameterized. In a Misspecification Equilibrium agents only select the best-performing statistical models. We demonstrate that, even when monetary policy rules satisfy the Taylor principle by adjusting nominal interest rates more than one for one with inflation, there may exist equilibria with Intrinsic Heterogeneity. Under certain conditions, there may exist multiple misspecification equilibria. We show that these findings have important implications for business cycle dynamics and for the design of monetary policy.
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The second author acknowledges support from the National Science Foundation.
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We are grateful to Mordecai Kurz, an anonymous referee, and participants at the SITE Workshop on Diverse Beliefs for comments.
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Open Access This is an open access article distributed under the terms of the Creative Commons Attribution Noncommercial License (https://creativecommons.org/licenses/by-nc/2.0), which permits any noncommercial use, distribution, and reproduction in any medium, provided the original author(s) and source are credited.
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Branch, W.A., Evans, G.W. Monetary policy and heterogeneous expectations. Econ Theory 47, 365–393 (2011). https://doi.org/10.1007/s00199-010-0539-9
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DOI: https://doi.org/10.1007/s00199-010-0539-9