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Optimal Monetary Policy Under Bounded Rationality

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Abstract and Figures

We build a behavioral New Keynesian model that emphasizes different forms of myopia for households and firms. By examining the optimal monetary policy within this model, we find four main results. First, in a framework where myopia distorts agents' inflation expectations, the optimal monetary policy entails implementing inflation targeting. Second, price level targeting emerges as the optimal policy under output gap, revenue, or interest rate myopia. Given that bygones are not bygones under price level targeting, rational inflation expectations are a minimal condition for optimality in a behavioral world. Third, we show that there are no feasible instrument rules for implementing the optimal monetary policy, casting doubt on the ability of simple Taylor rules to assist in the setting of monetary policy. Fourth, bounded rationality may be associated with welfare gains.
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Optimal Monetary Policy Under
Bounded Rationality
European Economic Association
35th Annual Congress
Jonathan Benchimol1and Lahcen Bounader2
This pre senta tion do es not n ecess arily re‡ect the v iews of t he Bank of Israe l
or the Int ernat ional M onetar y Fund, or a ny othe r institu tion.
August, 2020
1Bank of Israel
2International Monetary Fund
1 / 48
Empirical Motivation
IEssential concepts for CBs:
IManaging gaps (e.g., in‡ation, output).
Do agents measure/model/understand these gaps accurately ?
IManaging expectations.
Do agents measure/model/understand these expectations
accurately ?
ICollecting prices:
IMore or less easy supermarket/internet.
ICollecting values of the output gap:
ILess easy.
IMyopia(s) to in‡ation and output
)Relative distortion between prices and quantities
)(Optimal) monetary policy?
2 / 48
Theoretical Motivation
IOptimal monetary policy: rational NK models (Clarida et al.,
1999 and Woodford, 2003).
IAgents’expectations are exaggerated in New Keynesian
models (Blanchard, 2009).
IThe economy is inconsistent with any model of rationality
(Stiglitz, 2011).
IWhat is the optimal monetary policy when relaxing the
rational expectations hypothesis?
3 / 48
Literature
IInformation stickiness
Flexible or strict PLT is optimal (Ball, Mankiw, and Reis, 2005).
IRational inattention
Small di¤erences in terms of welfare compared to the rational
case (Mackowiak and Wiederholt, 2015).
ILearning
A form of PLT could be an adequate proxy of the optimal
policy (Eusepi and Preston, 2018).
IBehavioral New Keynesian
PLT is not desirable when …rms are behavioral (Gabaix, 2020).
4 / 48
Intuition
IHow agents’perceptions are key to monetary policy conduct?
IBounded rationality types in‡uence monetary policy reactions
and households’welfare di¤erently.
IIn‡ation expectations are pivotal to most targeting policies.
IDoes the behavioral agent’s welfare is necessarily lower than
the rational agent’s one?
IIgnoring some aspects of reality might be welfare increasing.
IWhy should mechanical rules hold whatever the state of the
world ?
IBehavioral states.
5 / 48
Model
IBuilding on the workhorse NK model and its behavioral
version (Gabaix, 2020).
IAgents are myopic to future disturbances: interest rate,
output-gap, in‡ation, real income, general and full myopia.
IBoundedly rational households and …rms, and rational CB.
IEncompasses the rational model and its policy
recommendations as a particular case.
IContributions:
IConsistent term structure of attention
)Original Phillips curve.
IVariable-speci…c myopias
)Bounded rationality tractability.
IDecreasing return to scale
)Realistic pass-through between real and nominal variables.
IFlexible-price economy
)Microfounded output-gap and natural interest rate.
IWelfare-relevant model
)Consistent optimal monetary policy evaluation.
6 / 48
Findings
IOptimal monetary policy is myopia-dependent.
IIf myopia distorts agents’in‡ation expectations, the optimal
policy entails an IT.
IOtherwise, the optimal policy is a PLT.
IRational in‡ation expectations are a minimal condition for
PLT optimality in a behavioral world.
ITo the extent that bygones are not bygones under PLT.
INo feasible instrument rules for implementing the optimal
monetary policy: casting doubt on the ability of simple Taylor
rules to be useful in guiding monetary policy.
IBounded rationality may be associated with welfare gains.
7 / 48
Environment
IBoundedly rational households maximize their life-time utility
subject to their budget constraint and a non-Ponzi scheme
condition.
¯mGeneral myopia
mrInterest rate myopia
myReal income myopia
IBoundedly rational …rms maximize their perceived pro…t
subject to production technology.
¯mGeneral myopia
mf
πIn‡ation myopia
mf
xOutput-gap myopia
ISticky-price economy: Calvo pricing mechanism.
8 / 48
Households
In…nitely-lived household maximizes
E0
t=0
βtU(ct,Nt)(1)
subject to
kt+1=1+rt+brBR
tktct+yt+byBR
t(2)
St+1=¯mf (St,et+1)(3)
where the following behavioral term structure of expectations
(BTSE) is assumed
EBR
t[b
Xt+k] = mXmkEt[b
Xt+k](4)
mX: level (intercept) of attention (contemporaneous attention).
m: slope of attention (cognitive discounting) as a function of the horizon (k).
9 / 48
IS Curve
IBehavioral IS curve
eyt=MEt[eyt+1]σ(itEt[πt+1]rn
t)(5)
I˜ytis the output gap
IM=MG=m/(RmY¯r)where
IR=1+¯r=1/β.
ImY=(φmy+γ)/(φ+γ).
Iσ=σG=mr/(γR(RmY¯r)).
IRational IS curve (mr=my=¯m=1)
˜yt=Et[˜yt+1]σre (itEt[πt+1]rn
t)(6)
Iσre =1/(γR).
10 / 48
Firms
IContinuum of …rms produces di¤erentiated goods using the
technology
Yt=AtN1α
t(7)
IBehavioral …rm maximizes
k=0
θk
pEBR
tΛt,t+kP
tYt+kjtΨt+kYt+kjt (8)
subject to the sequence of demand constraints.
IΛt,t+k: stochastic discount factor in nominal terms.
IΨt+k(.): cost function.
IYt+kjt: output in t+kfor a …rm that last reset its price in t.
IFOC:
p
tpt1=(1βθ)Θ
k=0
(βθ)kEBR
t[cmct+k]
+
k=0
(βθ)kEBR
t[πt+k](9)
11 / 48
Phillips Curve
IBehavioral Phillips curve
πt=βMfEt[πt+1]+κ˜yt(10)
IMf=θm
1(1θ)mf
π
Iκ=mf
x(1θ)(1βθ)
1(1θ)mf
π
Θγ+φ+α
1αwhere Θ=1α
1α+αe 1.
IRational Phillips curve (mf
x=mf
π=m=1)
πt=βEt[πt+1]+κre ˜yt(11)
Iκre =(1θ)(1βθ )
θΘγ+φ+α
1α.
12 / 48
Phillips Curve: Comparison
IOur behavioral Phillips curve
IMf=θm
1(1θ)mf
π
Iκ=mf
x(1θ)(1βθ)
1(1θ)mf
π
Θγ+φ+α
1α
IGabaix (2020) behavioral Phillips curve
IMf
G=mθ+1βθ
1βθmmf
π(1θ)
IκG=mf
x(1θ)(1βθ)
θ(γ+φ)
ICompared to Gabaix (2020), our fully microfounded Phillips
curve re‡ects a stronger role of mand the importance of
both, decreasing return to scale and in‡ation myopia in κ.
13 / 48
Phillips Curve: Contributions (1)
IGabaix (2020) apply the BTSE to
p
tpt1=(1βθ)
k=0
(βθ)kEBR
tπt+1+... +πt+kµt+k
where µt+k=mct+kis the level of real marginal cost.
IHowever, the BTSE should be applied to the deviation from
the steady state of the variable (Lemma 2.4).
IWe apply the BTSE to
p
tpt1=(1βθ)Θ
k=0
(βθ)kEBR
t[cmct+k]
+
k=0
(βθ)kEBR
t[πt+k](12)
ICorrect transition from subjective to objective expectations
)Our Phillips Curve is not nested in Gabaix (2020).
14 / 48
Phillips Curve: Contributions (2)
Iκ6=κGis related to our assumption of decreasing returns to
scale in the production function.
IGabaix (2020): constant return to scale )κG.
IOur formulation: κis a function of α(∂κ
∂α <0)
)lengthens the feedback from real to nominal variables.
IDecreasing return to scale
IMore realistic (Basu an d Fernal d, 1997 ; Jerma nn and Q uadrin i, 2007 )
IMore realistic role for in‡ation myopia in κ.
Iκis decreasing with αin the general case (α6=0):
IIncomplete feedback from output to in‡ation.
ICentral bank gives less weight to the output gap objective
compared to the constant return to scale case.
IMonetary policy should be more aggressive in bringing down
in‡ation. Intuition con…rmed by the robustness checks (cf.
decreasing vs. constant return to scale calibrations).
15 / 48
Summary
IBehavioral IS curve
eyt=MEt[eyt+1]σ(itEt[πt+1]rn
t)(13)
IBehavioral Phillips curve
πt=βMfEt[πt+1]+κ˜yt(14)
IMand Mfaugment both equations by reducing the excessive
weight given to rational expectations (Blanchard, 2009).
16 / 48
Welfare-Relevant De…nitions
INominal rigidities alongside real imperfections
)Ine¢ cient ‡exible price equilibrium
IOptimal for the central bank to target e¢ cient allocation
)Welfare-relevant variables.
)Model in terms of deviations wrt. e¢ cient aggregates
IWelfare-relevant output: xt=ytye
t
Iye
tis the e¢ cient output
IWelfare-relevant output gap: ˜yt=xt+(ye
tyn
t).
Iyn
tis the natural output (‡exible-price output).
17 / 48
Welfare-Relevant Model
IWelfare-relevant behavioral IS curve
xt=MEtxt+1σ(itEt[πt+1]re
t)(15)
IE¢ cient interest rate perceived by households:
re
t=rn
t+(1/σ)MEtye
t+1yn
t+1(ye
tyn
t)
IWelfare-relevant behavioral Phillips curve
πt=βMfEt[πt+1]+κxt+ut(16)
Iut=κ(ye
tyn
t)is an AR (1)cost-push shock (Galí, 2015)
ut=ρuut1+εu
tand εu
tN(0;σu),i.i.d. over time.
18 / 48
Model Calibration
Parameter Calibration Description
β0.996 Static discount factor
γ2 Household’s relative risk aversion
ε9 Elasticity of substitution between goods
α1/3 Return to scale
φ5 Frisch elasticity of labor supply
θ0.75 Probability of …rms not adjusting prices
ρa0.75 Technology shock persistence
ρu0.75 Cost-push shock persistence
Table 1: Model parameters: Calibration.
Source: Galí (2015).
19 / 48
Myopia Calibration
Models
No myopia Myopia
Rational Interest rate Output gap In‡ation Revenue General Full
mr1 0.85 1 1 1 1 0.85
mf
x1 1 0.85 1 1 1 0.85
mf
π1 1 1 0.85 1 1 0.85
my1 1 1 1 0.85 1 0.85
m1 1 1 1 1 0.85 0.85
Table 2: Myopia parameters: Calibration.
Source: Gabaix (2020).
20 / 48
Optimal Policy
IMicrofounded welfare loss measure derived from the second
order approximation of the behavioral household’s utility
W=1
2E0
t=0
βtπ2
t+wx
wπ
x2
t(17)
Iwπ=e
Θθ
(1βθ)(1θ),
Iwx=γ+φ+α
1α.
21 / 48
Commitment: Analytical Solution
ICentral bank:
ICredible + Able to commit to a policy plan )stabilization.
IChooses a path for the output gap and in‡ation over the
in…nitely lived horizon to minimize the welfare loss.
ICB problem FOCs (Lagrange multiplier: ϕt)
πt+ϕtMfϕt1=0 (18)
wx
wπ
xtκϕt=0 (19)
ISolution:
pt=wx
κwπ xt+1Mft1
j=0
xj!(20)
IA form of PLT is optimal when m=1 and mf
π=1.
IA form of IT is optimal when this condition is not satis…ed.
22 / 48
Commitment: Simulation
510 15 20
0
0.05
0.1
0.15 Inflation
510 15 20
-1.2
-1
-0.8
-0.6
-0.4
-0.2
Output
510 15 20
-0.2
0
0.2
0.4
0.6
Interest rate
510 15 20
0.05
0.1
0.15
0.2 Price level
Rational
Interest rate myopia
Output-gap myopia
Inflation myopia
Revenue myopia
General myopia
Full myopia
Figure 1: Commitment: Impulse response functions.
Note: responses to a 1% cost-push shock.
23 / 48
Commitment: Analysis
ISuboptimality of PLT under in‡ation, full and general
myopia.
IIT is optimal due to the welfare cost induced by CB’s
decisions to stabilize the price level in a world where people
are boundedly rational regarding in‡ation.
IOptimality of PLT under output gap, revenue, and interest
rate myopia.
ICB’s reactions: output gap, in‡ation, and revenue myopia are
very close to the rational case.
IStrong central bank reaction: interest rate,general and full
myopia.
IRemaining cases: optimal required action is smoother, and the
central bank improves the policy trade-o¤ in a way that allows
a de‡ation to operate and then the price level to be stationary.
24 / 48
Commitment: Welfare
No myopia Myopia
Rational Interest rate Output gap In‡ation Revenue General Full
0.174 0.174 0.227 0.190 0.174 0.176 0.248
Table 3: Commitment: Welfare losses.
IIntuitive: rational case generates the lowest welfare loss.
IInterest rate and revenue myopia: same welfare losses as the
rational benchmark.
IThe CB loss does not penalize deviations of interest rate or
revenue: agents are well-informed about output and in‡ation
in these two cases.
IGeneral myopia: close to these cases.
IBounded rationality: not necessarily welfare decreasing.
25 / 48
Discretion: Analytical Solution
ICB “not bound by previous actions or plans and thus is free to
make an independent decision every period” (Plosser, 2007)
IMakes whatever decision is optimal in each period without
committing itself to any future actions.
IMinimizes the welfare loss related to the decision period,
taking into account that expectations are given.
IOptimal discretionary CB should follow this targeting criterion:
πt=wx
κwπ
xt(21)
IAfter a cost-push shock, a discretionary central bank has to
keep this proposition satis…ed to minimize the welfare loss.
IWhen in‡ationary pressures arise, the policymaker has an
incentive to drive output below its e¢ cient level to
accommodate the cost-push shock.
IProposition silent about the in‡uence of bounded rationality.
26 / 48
Discretion: Myopia
ICombining and solving forward:
πt=
wx
wπ
wx
wπ+κ2wx
wπβMfρu
ut(22)
xt=κ
wx
wπ+κ2wx
wπβMfρu
ut(23)
ICB has to let the output gap and in‡ation deviate
proportionally to the cost-push shock (ut).
IBounded rationality in‡uences the magnitudes of these
deviations through κ(mf
x,mf
π) and Mf(m,mf
π).
IOptimal policy response )indeterminate price level but
determinate in‡ation )a form of IT is the preferred regime.
IBounded rationality under discretion in‡uences magnitudes of
the reactions to a shock but does not impact the choice of
the policy regime.
27 / 48
Discretion: Simulation
510 15 20
0.05
0.1
0.15
Inflation
510 15 20
-1.5
-1
-0.5
Output
510 15 20
0.2
0.4
0.6
0.8
1
1.2
Interest rate
510 15 20
0.2
0.4
0.6
Price level
Rational
Interest rate myopia
Output- gap myopia
Inflation myopia
Revenue myopia
General myopia
Full myopia
Figure 2: Discretion: Impulse response functions.
Note: responses to a 1% cost-push shock.
28 / 48
Discretion: Welfare
IIT regime is always the desirable monetary policy.
No myopia Myopia
Rational Interest rate Output gap In‡ation Revenue General Full
0.270 0.270 0.386 0.287 0.270 0.236 0.341
Table 4: Discretion: Welfare losses.
IAlthough this result could seem counterintuitive, general
myopia impacts the level of expectations of all
macroeconomic variables of the model. In this case, people’s
expectations are distorted, which is consistent with a
discretionary policymaker.
29 / 48
Optimal Simple Rules
Name Targeting regime Instrument-rule
F1 Flexible in‡ation it=φππt+φy˜yt
F2 Flexible price level it=φppt+φy˜yt
F3 Flexible NGDP growth it=φg(πt+˜yt)+φy˜yt
F4 Flexible NGDP level it=φn(pt+˜yt)+φy˜yt
S1 Strict in‡ation it=φππt
S2 Strict price level it=φppt
S3 Strict NGDP growth it=φg(πt+˜yt)
S4 Strict NGDP level it=φn(pt+˜yt)
Table 5: Optimal simple rules: Description
30 / 48
Optimal Simple Rules: Coe¢ cients
F1 F2 F3 F4 S1 S2 S3 S4
φπφyφpφyφgφyφnφyφπφpφgφn
No (rational) 1.96 0.25 0.33 0.0 2.62 0.5 0.17 0.0 2.37 0.34 3.90 0.17
Interest rate 2.44 0.20 0.39 0.0 3.32 0.5 0.20 0.0 3.11 0.40 4.00 0.20
Output gap 1.39 0.32 0.26 0.0 1.81 0.5 0.13 0.0 2.02 0.27 3.43 0.13
In‡ation 1.43 0.27 0.30 0.0 1.55 0.5 0.15 0.0 1.99 0.31 3.26 0.15
Revenue 2.03 0.21 0.33 0.0 2.63 0.5 0.17 0.0 2.37 0.34 3.91 0.17
General 2.05 0.14 0.56 0.0 1.61 0.5 0.25 0.0 2.38 0.58 3.34 0.25
Full 1.54 0.18 0.49 0.0 1.10 0.5 0.21 0.0 2.10 0.50 2.82 0.21
Table 6: Optimal simple rules: Coe¢ cients.
31 / 48
Optimal Simple Rules: Myopia
IThe CB reacts di¤erently under each regime for each
myopia.
IMyopia in‡uences the
Isensitivity of the policy instrument to the CB target.
Itransmission of monetary policy to the output gap.
Itransmission from the output gap to nominal variables.
Itransmission from expectations to in‡ation.
ICB behavior (to control its target).
IUnder general and full myopia, the CB should react
aggressively to:
Icurb expectations.
Iimpact the desired variables.
32 / 48
Optimal Simple Rules: Regimes
ICB more sensitive to its target when operating under strict
targeting compared to ‡exible targeting.
IIn line with Rudebusch (2002) and Benchimol and Fourçans
(2019):
IThe strict NGDP growth targeting coe¢ cients (S3) are higher
than for the ‡exible NGDP growth targeting coe¢ cients (F3)
across all myopia types.
IWhen the central bank targets the NGDP level (F4 and S4) or
the price level (F2 and S2), the coe¢ cients are positive but
lower than one.
IDivine coincidence between stabilizing the price level and the
output gap )a form of PLT leads to self-stabilizing
dynamics for the output gap.
33 / 48
Optimal Simple Rules: Welfare
F1 F2 F3 F4 S1 S2 S3 S4
Regimes
Rational
Interest rate
Output gap
Inflation
Revenue
General
Full
Myopia
0.2093
0.2093
0.2264
0.2093
0.1997
0.1766
0.1766
0.1923
0.1766
0.1773
0.2161
0.2162
0.2361
0.2161
0.2110
0.1855
0.1857
0.2016
0.1855
0.1840
0.2093
0.2094
0.2264
0.2093
0.1997
0.1762
0.1763
0.1919
0.1762
0.1772
0.2167
0.2168
0.2378
0.2167
0.2134
0.1852
0.1854
0.2013
0.1853
0.1838
0.2848
0.2849
0.2317
0.2518
0.2976
0.3091
0.2456
0.2612
0.2848
0.2849
0.2310
0.2517
0.2993
0.3205
0.2450
0.2609
Figure 3: Optimal simple rules: Welfare losses.
Note: the shading scheme is de…ned separately in relation to each column. The
lighter the shading is, the smaller the welfare loss.
34 / 48
Optimal Simple Rules: Welfare
IFlexible targeting rules do not necessarily induce welfare losses
compared to strict rules.
IMost exible targeting rules generate similar welfare losses
compared to their corresponding strict targeting rules.
IStrict PLT delivers the lowest welfare among the considered
rules, similar to the ‡exible PLT rule through di¤erent myopia
cases (divine coincidence when PLT CB).
IRational case delivers similar welfare losses to interest rate and
revenue myopia cases as in commitment and discretion cases.
IThe best monetary policy rule is the strict PLT rule,
whatever types of myopia considered.
IInability of these simple rules to replicate the …rst best
solution (commitment) )optimal policy depends on the
type of myopia characterizing agents.
35 / 48
Robustness: Model Parameters
Calibration name β γ φ e α θ
Galí (2008) 0.99 1 1 6 1/3 0.66
Relative risk aversion 0.99 2 1 6 1/3 0.66
Frisch elasticity 0.99 1 5 6 1/3 0.66
Constant return to scale 0.99 1 1 6 0 0.66
Sticky prices 0.99 1 1 6 1/3 3/4
Time preferences 0.996 1 1 6 1/3 0.66
Demand elasticity 0.99 1 1 9 1/3 0.66
Galí (2015) 0.996 2 5 9 1/3 3/4
Table 7: Calibration of the model parameters used for the robustness
checks.
36 / 48
Robustness: Commitment
Gali (2008)
Relative risk aversion
Frisch elasticity
Constant return to scale
Sticky prices
Time preference
Demand elasticity
Gali (2015)
Rational
Interest rate
Output-gap
Inflation
Revenue
General
Full
Myopia
0.2809
0.2809
0.3171
0.2809
0.2834
0.2235
0.2235
0.2533
0.2235
0.2257
0.1126
0.1126
0.1286
0.1126
0.1136
0.1248
0.1248
0.1424
0.1248
0.1260
0.4667
0.4667
0.5039
0.4667
0.4672
0.2832
0.2832
0.3199
0.2832
0.2861
0.2624
0.2624
0.2966
0.2624
0.2648
0.1741
0.1741
0.1901
0.1741
0.1760
0.3599
0.3962
0.2892
0.3223
0.1492
0.1699
0.1649
0.1873
0.5830
0.6043
0.3627
0.4001
0.3372
0.3727
0.2274
0.2478
Table 8: Commitment: Welfare losses.
37 / 48
Robustness: Discretion
Gali (2008)
Relative risk aversion
Frisch elasticity
Constant return to scale
Sticky prices
Time preference
Demand elasticity
Gali (2015)
Rational
Interest rate
Output-gap
Inflation
Revenue
General
Full
Myopia
0.5102
0.5102
0.5324
0.5102
0.4149
0.5625
0.3740
0.3740
0.4005
0.3740
0.3165
0.1528
0.1528
0.1713
0.1528
0.1403
0.1740
0.1740
0.1942
0.1740
0.1583
1.0109
1.0109
0.9864
1.0109
0.7347
0.8907
0.5212
0.5212
0.5432
0.5212
0.4222
0.5721
0.4649
0.4649
0.4892
0.4649
0.3828
0.2697
0.2697
0.2868
0.2697
0.2362
0.7148 0.5308
0.4484
0.2189
0.2155
0.2494
0.2412
1.3426 0.7315 0.6543
0.5264
0.3862
0.3407
Table 9: Discretion: Welfare losses.
38 / 48
Robustness: Myopia Parameters
Models
No myopia Myopia
Rational Interest rate Output gap In‡ation Revenue General Full Extreme
mr1 0.2 1 1 1 1 0.2 0.01
mf
x1 1 0.2 1 1 1 0.2 0.01
mf
π1 1 1 0.2 1 1 0.2 0.01
my1 1 1 1 0.2 1 0.2 0.01
m1 1 1 1 1 0.2 0.2 0.01
Table 10: Calibration of the myopia parameters used for the robustness
checks.
39 / 48
Robustness: Commitment
510 15 20
0
0.2
0.4
Inflation
510 15 20
-1.5
-1
-0.5
Output
510 15 20
0
1
2
3
Interest rate
510 15 20
0.2
0.4
0.6
0.8
1
Price level
Rational
Interest rate myopia
Output-gap myopia
Inflation myopia
Revenue myopia
General myopia
Full myopia
Extreme myopia
Figure 4: Commitment: Robustness.
Note: Impulse response functions to a 1% cost-push shock.
40 / 48
Robustness: Discretion
510 15 20
0.2
0.4
0.6
0.8
Inflation
510 15 20
-1.4
-1.2
-1
-0.8
-0.6
-0.4
-0.2
Output
510 15 20
1
2
3
Interest rate
510 15 20
1
2
3
Price level
Rational
Interest rate myopia
Output-gap myopia
Inflation myopia
Revenue myopia
General myopia
Full myopia
Extreme myopia
Figure 5: Discretion: Robustness.
Note: Impulse response functions to a 1% cost-push shock.
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Robustness: Welfare
Myopia
Interest rate Output gap In‡ation Revenue General Full Extreme
Commitment 0.174 1.446 0.257 0.174 0.143 0.372 0.302
Discretion 0.270 3.357 0.348 0.270 0.145 0.372 0.302
Table 11: Welfare losses: Robustness.
Note: Model calibration: Table 1. Myopia calibration: Table 10.
IWelfare losses under discretion are always higher than under
commitment, except under full and extreme myopia.
IGeneral myopia leads to the best welfare losses under
commitment and discretion )myopia may improve
welfare.
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Discussion
IThe rational expectations literature results about optimal
monetary policy are nested in our model (Fuhrer and Moore,
1995; Galí and Gertler, 1999; Walsh, 2017; Woodford, 2003, 2010).
IOptimal policy is myopia-dependent.
IOptimality of a form of PLT (interest rate, output gap or
revenue myopia) and IT (remaining cases) 6=literature
IInformation stickiness (Ball, Mankiw and Reis, 2005),
IRational Inattention (Mackowiak and Wiederholt, 2009, 2015),
ILearning (Eusepi and Preston, 2018),
IBehavioral NK (Gabaix, 2020).
IInability of simple rules to replicate the …rst best solution:
casting doubt on their usefulness in the CB toolkit.
ISvensson (2003): the concept of targeting rules is more
appropriate to the forward-looking nature of monetary policy.
IBounded rationality is not necessarily associated with welfare
losses.
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Bridging the gap
IRevision of the IT framework after the GFC (Bernanke, 2017;
Evans, 2018;Blanchard and Summers, 2019).
IPLT overcome the challenges brought by the Zero Lower
Bound (Bernanke, 2017).
ICurrent IT + some adjustments to its parameters: raising the
in‡ation target (Blanchard and Summers, 2019) or allowing
interest rates to be negative.
IBefore the crisis, debate between IT and PLT (Svensson, 1999).
IWe bridge the gap between these competing views:
IBoth forms of targeting (PLT and IT) could be optimal but in
di¤erent circumstances.
IAssessing bounded rationality is a crucial indicator for the CB
targeting policy.
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Policy implications (1)
IAgents’expectations matter for monetary policy conduct.
IManaging expectations in a behavioral world
)deviate from a mechanical rule
)more room for adapting policies according to people’s
perceptions.
IPolicymakers’educate the public through intensive
communication
)increase public understanding and trust of their monetary
policies, among other objectives
)attenuate myopia
)may increase welfare.
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Policy implications (2)
ICentral banks have to explore,monitor, and analyze agents’
myopia.
IAssessing the degree to which economic agents are myopic is
one of the areas that central banks should invest in more.
IBorrowing an analogy from Thaler (2016), the central bank
Ishould invest in studying the degree to which Homo sapiens
are myopic
Iact consistently rather than educate people and attempt to
transform humans into Homo economicus.
ICall for targeting rules, considering myopia, in the central
banking apparatus in setting monetary policy decisions.
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Summary
INo de…nitive answer: neither IT nor PLT is consistently
optimal under all states of the world.
IBounded rationality matters for the conduct of monetary
policy.
IOptimal simple rules: strict PLT in all bounded rationality
cases )puzzling observation about replicating the …rst-best
solution.
IInability of simple rules to replicate the …rst best solution calls
for a reconsideration of their roles in the conduct of monetary
policy.
INew re‡ection about the instrument rules in an economy
with behavioral agents.
IBounded rationality is not necessarily associated with
decreased welfare.
IThe central bank has to identify,assess and monitor
di¤erent myopia types to conduct monetary policy optimally.
47 / 48
Thanks
Thank you for your attention
IComments
IUpdated paper: JonathanBenchimol.com
IEmail: jonathan@benchimol.name
ISocial
ITwitter: @Benchimolium
ILinkedIn: Linkedin.com/in/Benchimol/
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... 16 While Gabaix (2020) embeds bounded rationality in a NK model, the basic idea of behavioral inattention (or sparsity) has been proposed by Gabaix earlier already (see Gabaix (2014Gabaix ( , 2016) and a handbook treatment of behavioral inattention is given in Gabaix (2019). Benchimol and Bounader (2019) and Bonciani and Oh (2021) study optimal monetary policy in a RANK and TANK model, respectively, with this kind of behavioral frictions. 17 Gabaix (2020) focuses on the case in which X t denotes the state of the economy. ...
... The Cognitive Discounting Parameterm. The cognitive discounting parameterm is set to 0.85, as in Gabaix (2020) and Benchimol and Bounader (2019). Fuhrer and Rudebusch (2004), for example, estimate an IS equation and find thatmδ ≈ 0.65, which together with δ > 1, would imply am much lower than 0.85 and especially our determinacy results would be even stronger under such a calibration. ...
... which collapses to the canonical New Keynesian Phillips curve for m = 1. Note that, in line with Benchimol and Bounader (2019) and the principle stated in Section 3.1, we deviate from Gabaix (2020) while deriving equation 15 (see also Appendix A.4 for details). However, this deviation does not have a material impact on any of our key results. ...
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We build a behavioral New Keynesian model that emphasizes different forms of myopia for households and firms. By examining the optimal monetary policy within this model, we find four main results. First, in a framework where myopia distorts agents' inflation expectations, the optimal monetary policy entails implementing inflation targeting. Second, price level targeting emerges as the optimal policy under output gap, revenue, or interest rate myopia. Given that bygones are not bygones under price level targeting, rational inflation expectations are a minimal condition for optimality in a behavioral world. Third, we show that there are no feasible instrument rules for implementing the optimal monetary policy, casting doubt on the ability of simple Taylor rules to assist in the setting of monetary policy. Fourth, bounded rationality may be associated with welfare gains.
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