Abstract
This paper analyzes monetary policy in a behavioral model with potential unanchoring of expectations. The extent to which expectations are anchored is determined in an adaptive learning setting by the private sector’s endogenously time-varying learning gain. Within the context of an otherwise standard macro model with nominal rigidities and natural-rate and cost-push shocks, I find that optimal policy involves an aggressive interest rate response to any threat of expectations unanchoring. This stabilizes both inflation expectations and inflation, allowing the central bank to accommodate inflation fluctuations when expectations are well anchored. Furthermore, I estimate the model-implied relationship that determines the extent of unanchoring. The data suggest that the expectation process is nonlinear: expectations exhibit a higher sensitivity to large forecast errors than to smaller ones.
Local Organizers: Vincenzo Scrutinio, Annalisa Loviglio