The Role of Expectations in Economic Fluctuations and the Efficacy of Monetary Policy

54 Pages Posted: 20 Dec 2003

See all articles by Mordecai Kurz

Mordecai Kurz

Stanford University - Department of Economics

Hehui Jin

Stanford University

Maurizio Motolese

Catholic University of Milan

Date Written: November 12, 2003

Abstract

We show diverse beliefs is an important propagation mechanism of fluctuations, money non neutrality and efficacy of monetary policy. Since expectations affect demand, our theory shows economic fluctuations are mostly driven by varying demand not supply shocks. Using a competitive model with flexible prices in which agents hold Rational Belief (see Kurz (1994)) we show that (i) our economy replicates well the empirical record of fluctuations in the U.S. (ii) Under monetary rules without discretion, monetary policy has a strong stabilization effect and an aggressive anti-inflationary policy can reduce inflation volatility to zero. (iii) The statistical Phillips Curve changes substantially with policy instruments and activist policy rules render it vertical. (iv) Although prices are flexible, money shocks result in less than proportional changes in inflation hence the aggregate price level appears "sticky" with respect to money shocks. (v) Discretion in monetary policy adds a random element to policy and increases volatility. The impact of discretion on the efficacy of policy depends upon the structure of market beliefs about future discretionary decisions. We study two rationalizable beliefs. In one case, market beliefs weaken the effect of policy and in the second, beliefs bolster policy outcomes and discretion could be a desirable attribute of the policy rule. Since the central bank does not know any more than the private sector, real social gain from discretion arise only in extraordinary cases. Hence, the weight of the argument leads us to conclude that bank's policy should be transparent and abandon discretion except for rare and unusual circumstances. (vi) An implication of our model suggests the current effective policy is only mildly activist and aims mostly to target inflation.

Keywords: Monetary policy rules, Money non neutrality, Business cycles, Market volatility, Propagation mechanism, Capacity utilization, Heterogenous beliefs, Over confidence, Rational Belief, Optimism; Pessimism, Non stationarity, Empirical distribution

JEL Classification: E31, E32, E52, E58, D58

Suggested Citation

Kurz, Mordecai and Jin, Hehui and Motolese, Maurizio, The Role of Expectations in Economic Fluctuations and the Efficacy of Monetary Policy (November 12, 2003). Available at SSRN: https://ssrn.com/abstract=477861 or http://dx.doi.org/10.2139/ssrn.477861

Mordecai Kurz (Contact Author)

Stanford University - Department of Economics ( email )

Landau Economics Building
579 Serra Mall
Stanford, CA 94305-6072
United States

Hehui Jin

Stanford University ( email )

Stanford, CA 94305
United States

Maurizio Motolese

Catholic University of Milan ( email )

L.go A. Gemelli, 1
Milano, MI 20123
Italy
+39-02-72342418 (Phone)

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