Adaptive Learning and Monetary Policy in an Open Economy: Lessons From Japan

Abstract

Motivated by Japan's economic experiences and policy debates over the past two decades, this paper uses an open economy dynamic stochastic general equilibrium model to examine the volatility and welfare impact of alternative monetary policies. To capture the dynamic effects of likely structural breaks in the Japanese economy, we model agents' expectation formation process with an adaptive learning framework, and compare four Taylor-styled policy rules that reflect concerns commonly raised in Japan's actual monetary policy debate. We first show that imperfect knowledge and the associated learning process induce higher volatility in the economy, while retaining some of the policy conclusions from rational-expectations setups. In particular, explicit exchange rate stabilization is unwarranted, and under volatile foreign disturbances, policymakers should consider targeting domestic price inflation rather than consumer price inflation. However, contrary to results based on rational expectations, we show that even though highly inflation-sensitive rules do raise output volatility, they may nevertheless improve overall welfare in an adaptive learning setting by smoothing inflation fluctuations. Our findings suggest that previous policy conclusions that are based on partial equilibrium analyses, or that ignore likely deviations from rational expectations, may not be robust. JEL classification: D84; E52; F41Keywords: Adaptive learning; Monetary policy rules; Open economy ____________________________ * We thank, without implicating, Drew Creal, George Evans, Seppo Honkapohja, Ben McCallum, Athanasios Orphanides, Richard Startz, George Waters, John Williams, Noah Williams, Wei-Choun Yu, and seminar participants at the Federal Reserve Bank of San Francisco and University of Washington for useful comments and suggestions. We also thank Arita Thatte for research assistance. Any remaining errors are our own.

Adaptive Learning, Persistence, and Optimal Monetary Policy

“…In this paper, we follow the convention in the adaptive learning literature and assume that the structural relations (besides the expectations operator) remain identical when moving from rational expectations to adaptive learning. function (2). In this case, it turns out that optimal monetary policy under discretion responds to the exogenous shock but not to lagged inflation (in contrast to when the loss function consists of squared inflation and output; see Clarida, Galí, and Gertler 1999).…”

“…We will assume here that the central bank uses the social welfare function to guide its policy decisions, both under rational expectations and under private sector learning. 2 If γ = 1, then the optimal rate of inflation is zero (otherwise there will be inefficient dispersion of prices in the steady state), and we therefore assume that the known inflation target (coinciding with the average level of inflation in the absence of an overambitious output gap target) equals this level. To keep the model simple, we assume that the central bank controls the output gap directly.…”

Credit Constraint and the Asymmetric Monetary Policy Effect on House Prices

“…With the extremely low interest rates, the expansionary monetary policies following the financial crisis, including quantitative easing during 2001-2006, appeared ineffective. See, for example, Bae et al (2006), Chen and Kulthanavit (2008), Iwamura et al (2005) and Svensson (2001). Another strand of the literature studies the asymmetric effect of monetary policy under different states of the economy.…”