4Non-technical summary 5

No abstract

4Non-technical summary 5

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This paper characterizes optimal monetary policy in an economy where inflation expectations are formed through adaptive learning. We assume that the central bank has full information about the structure of the economy (this is standard under rational expectations), including knowledge about the precise mechanism generating private sector expectations. Because a similar assumption is also implicit in the rational expectations literature, it should provide a useful benchmark for comparing optimal monetary policy under adaptive learning and rational expectations. ECB Working Paper Series No 644June 2006 The paper shows that, when private sector expectations are formed in line with adaptive learning, optimal policy responds in a persistent way to cost-push shocks. Through its persistent response to shocks -coupled with optimal response to state variables -the central bank reduces inflation persistence and inflation volatility at little cost in terms of output gap volatility. Persistent response 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.Specifically, in the event of a positive cost-push shock, optimal policy under commitment creates an output gap that persists long after the transitory shock has faded away. The intuition is that, by doing so, optimal policy lowers price expectations moderating the current increases in prices; thus the impact of the original shock is spread out over time. In the case of adaptive learning, the mechanism at play is based on the reduction in the estimated inflation persistence parameter based on data generated by shocks and policy responses.By creating a track record of stable inflation, the central bank anchors inflation expectations, thereby reinforcing its ability to maintain stability. Finally, for research on inflation persistence an important finding is that inflation is timevarying even if the inflation target remains unchanged. Thus, adaptive learning is relevant when interpreting empirical estimates of inflation persistence.