Imperfect Knowledge, Inflation Expectations, and Monetary Policy

This paper investigates the role that imperfect knowledge about the structure of the economy plays in the formation of expectations, macroeconomic dynamics, and the efficient formulation of monetary policy. Economic agents rely on an adaptive learning technology to form expectations and continuously update their beliefs regarding the dynamic structure of the economy based on incoming data. The process of perpetual learning introduces an additional layer of dynamic interactions between monetary policy and economic outcomes. We find that policies that would be efficient under rational expectations can perform poorly when knowledge is imperfect. In particular, policies that fail to maintain tight control over inflation are prone to episodes in which the public’s expectations of inflation become uncoupled from the policy objective and stagnation results, in a pattern similar to that experienced in the United States during the 1970s. More generally, we show that policy should respond more aggressively to inflation under imperfect knowledge than under perfect knowledge.