Template-Type: ReDIF-Paper 1.0
Author-Name: Mordecai Kurz
Author-X-Name-First: Mordecai
Author-X-Name-Last: Kurz

Author-Name: Maurizio Motolese
Author-X-Name-First: Maurizio 
Author-X-Name-Last:  Motolese


Author-Email: maurizio.motolese@unicatt.it
Author-Workplace-Name: Università Cattolica del Sacro Cuore
Author-Workplace-Name: Dipartimento di Economia e Finanza, Università Cattolica del Sacro Cuore

Author-Name: Giulia Piccillo
Author-X-Name-First: Giulia 
Author-X-Name-Last:  Piccillo

Author-Name: Howei Wu
Author-X-Name-First: Howei
Author-X-Name-Last: Wu


Title: Monetary Policy with Diverse Private Expectations
Abstract: We study the impact of diverse beliefs on conduct of monetary policy. Individual belief is modeled by
a state variable that defines an individual’s perceived laws of motion. We use a New Keynesian Model that is
solved with a quadratic approximation hence individual decisions are quadratic functions. Aggregation renders the
belief distribution an aggregate state variable. Although the model has standard technology and policy shocks,
diverse expectations change materially standard results about a smooth trade-off between inflation volatility and
output volatility. Our main results are summed up as follows:
(i) The policy space contains a curve of singularity which is a collection of policy parameters that divides the space
into two sub-regions. Some trade-off between output and inflation volatilities exists within each region and some
across regions. (ii) The singularity causes volatility of variables to be non monotone in policy parameters. Policymakers
cannot assume a more aggressive policy will change outcomes in a predictable manner. (iii) When beliefs
are diverse a central bank must also consider the volatility of individual consumption and the related volatility of
financial markets. We show aggressive anti-inflation policy increases consumption volatility and aggressive output
stabilization policy entails rising inflation volatility. Efficient central bank policy must therefore be moderate.
(iv) High optimism about the future typically lowers aggregate output and increases inflation. This “stagflation”
effect is stronger the stickier prices are. Policy response is muted since the effects of higher inflation and lower
output on interest rates partially cancel each other. Effective policy requires targeting exuberance directly or its
effects in asset markets. Central banks already do so with short term interventions. (v) The observed high serial
correlation of 0.80 in policy shocks contributes greatly to market volatility and we show that a reduction in
persistence of central bank’s deviations from a fixed rule will contribute to stability. (vi) Belief dispersion is
measured by cross sectional standard deviation of individual beliefs. An increased belief diversity is found to make
policy coordination harder and results in lower aggregate output and lower rate of inflation. Bank policy can
lower belief dispersion by being more transparent.
Length: 46
Creation-Date: 2015-01
File-URL: http://dipartimenti.unicatt.it/economia-finanza-def022.pdf
File-Format: Application/pdf
File-Function: First version, 2014
Number: def022
Classification-JEL: C53, D8, D84, E27, E42, E52 G12, G14. 
Keywords: New Keynesian Model; heterogenous beliefs; market state of belief; Rational Beliefs;
monetary policy rule
Handle: RePEc:ctc:serie1:def022