Abstract

We study monetary policy in a New Keynesian model where there is heterogeneity in expectations, and where agents adjust their expectations based on past performance. The behavioral parameters of the model turn out to be crucial in determining whether the central bank can achieve its inflation and output targets. These parameters first of all determine whether aggregate expectations stay close to the targets of the central bank after large shocks (the "inherent credibility" of the central bank). Secondly the behavioral parameters determine to what extent agents can coordinate on a specific expectation value. When this "potential homogeneity" is high, agents can easily coordinate on the targets of the central bank, but also on nearly self-fulfilling waves of optimism and pessimism. Global stability can than only be achieved with aggressive monetary policy. When the zero lower bound on the nominal interest rate (ZLB) is accounted for, aggressive monetary policy alone is no longer enough to guarantee global stability. Either a high inherent credibility, or a high inflation target is than needed to prevent the economy from falling into a liquidity trap after a series of negative shocks.

Lunch will be provided for those attending the seminar.

For more information please contact Joep Lustenhouwer (J/K 2.09).

Location