Bounded rationality, monetary policy, and macroeconomic stability

Abstract

This paper estimates a Behavioral New Keynesian model to revisit the evidence that passive US monetary policy in the pre-1979 sample led to indeterminate equilibria and sunspot-driven fluctuations, while active policy after 1982, by satisfying the Taylor principle, was instrumental in restoring macroeconomic stability. The model assumes "cognitive discounting", i.e., consumers and firms pay less attention to variables further into the future. We estimate the model allowing for both determinacy and indeterminacy. The empirical results show that determinacy is preferred both before and after 1979. Even if monetary policy is found to react only mildly to inflation pre-Volcker, the substantial degrees of bounded rationality that we estimate prevent the economy from falling into indeterminacy.

Monetary Policy Rules under Bounded Rationality

“…35 Instead of choosing a specific prior for the degree of myopia, we opt to remain agnostic and run multiple estimations with different prior means and standard deviations. For this purpose we take Ilabaca et al (2020) and Erceg et al (2021) as polar cases and estimate our 34 This is the estimated posterior mean of their expectational assumption that is comparable to ours. They show that the posterior mean of the myopia parameter varies quite a lot with the underlying expectational assumption.…”

“…Papers that allow for a flexible, more agnostic prior typically estimate a high degree of myopia. Ilabaca et al (2020) estimate a posterior mean between 0.41 and 0.60 for firms and between 0.71 and 0.85 for households assuming a beta prior with mean 0.8 and standard deviation 0.15. Meggiorini and Milani (2021) choose the same prior but arrive at a lower posterior mean of 0.42.…”

Mixed Monetary–Fiscal Policies and Macroeconomic Fluctuations: An Analysis Based on the Dynamic Stochastic General Equilibrium Model

“…As a result, macroeconomic fluctuations stabilized in the US. However, subsequent literature pointed out that, on the one hand, the above results relied on the traditional assumption that the expectation is rational (Ilabaca et al, 2020). On the other hand, the macroeconomic instability observed in the 1970s was caused by overconfi dence in output stabilization targets and overpessimistic estimates of output gaps (Orphanides, 2002(Orphanides, , 2003(Orphanides, , 2004.…”

Behavioral New Keynesian Models: Learning vs. Cognitive Discounting

“…In this area, our paper aims to provide further empirical evidence on the importance of cognitive discounting. Behavioral New Keynesian models with cognitive discounting are estimated in Ilabaca, Meggiorini, and Milani (2020), Meggiorini (2020), and Andrade, Cordeiro and Lambais (2019). This paper shows that the importance of the newly added behavioral feature is sensitive to the modeling of expectations.…”