Learning and optimal monetary policy

• Published in: Journal of economic dynamics & control Vol. 32; no. 6; pp. 1964 - 1994
• Main Authors: Dennis, Richard, Ravenna, Federico
• Format: Journal Article
• Language: English
• Published: Amsterdam Elsevier B.V 01-06-2008; Elsevier; Elsevier Sequoia S.A
• Series: Journal of Economic Dynamics and Control
• Subjects: Central banks; Impact analysis; Inflation; Learning; Monetary policy; Optimal policy; Rational expectations; Studies; Transparency; Learning; E58; E31; Transparency; E52; Optimal policy
• ISSN: 0165-1889; 1879-1743
• DOI: 10.1016/j.jedc.2007.08.002

To conduct policy efficiently, central banks must use available data to infer, or learn, the relevant structural relationships in the economy. However, because a central bank's policy affects economic outcomes, the chosen policy may help or hinder its efforts to learn. This paper examines whether real-time learning allows a central bank to learn the economy's underlying structure and studies the impact that learning has on the performance of optimal policies under a variety of learning environments. Our main results are as follows. First, when monetary policy is formulated as an optimal discretionary targeting rule, we find that the rational expectations equilibrium and the optimal policy are real-time learnable. This result is robust to a range of assumptions concerning private-sector learning behavior. Second, when policy is set with discretion, learning can lead to outcomes that are better than if the model parameters are known. Finally, if the private sector is learning, then unannounced changes to the policy regime, particularly changes to the inflation target, can raise policy loss considerably.