Adaptive Learning, Persistence, and Optimal Monetary Policy

28 Pages Posted: 30 Jun 2006

See all articles by Vítor Gaspar

Vítor Gaspar

Bank of Portugal

Frank Smets

European Central Bank (ECB); KU Leuven - Center for Economic Studies

David Vestin

European Central Bank (ECB)

Date Written: June 2006

Abstract

We show that, when private sector expectations are determined in line with adaptive learning, optimal policy responds persistently to cost-push shocks. The optimal response is stronger and more persistent, the higher is the initial level of perceived inflation persistence by the private sector. Such a sophisticated policy reduces inflation persistence and inflation volatility at little cost in terms of output gap volatility. Persistent responses to cost-push shocks and stability of inflation expectations resemble optimal policy under commitment and rational expectations. Nevertheless, it is clear that the mechanism at play is very different. In the case of commitment it relies on expectations of future policy actions affecting inflation expectations; in the case of sophisticated central banking it relies on the reduction in the estimated inflation persistence parameter based on inflation data generated by shocks and policy responses.

Keywords: Adaptive learning, rational expectations, policy rules, optimal policy

JEL Classification: E52

Suggested Citation

Gaspar, Vítor and Smets, Frank and Vestin, David, Adaptive Learning, Persistence, and Optimal Monetary Policy (June 2006). ECB Working Paper No. 644, Available at SSRN: https://ssrn.com/abstract=907313

Vítor Gaspar (Contact Author)

Bank of Portugal ( email )

Rua Francisco Ribeiro, 2
Lisbon, 1150-165
Portugal

Frank Smets

European Central Bank (ECB) ( email )

Kaiserstrasse 29
D-60311 Frankfurt am Main
Germany
+49 69 1344 6550 (Phone)
+49 69 1344 6575 (Fax)

KU Leuven - Center for Economic Studies ( email )

Naamsestraat 69
Leuven, B-3000
Belgium

David Vestin

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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