The Danger of Inflating Expectations of Macroeconomic Stability: Heuristic Switching in an Overlapping Generations Monetary Model

Abstract

We use a monetary overlapping-generations model to discuss the cause and durability of the marked fall in the volatility of inflation in recent decades. In our model, agents have to forecast inflation, and they do so using two "heuristics." One is based on lagged inflation, the other on an inflation target announced by the central bank. Agents switch between those heuristics based on an imperfect assessment of how each has performed in the past. The way the economy propagates productivity shocks into inflation depends on the proportion of agents using each heuristic. Movements in these proportions generate fluctuations in small-sample measures of economic volatility. We use this simple model of heuristic switching to contrast the performance of monetary policy rules. We find that, relative to the rule that would be optimal under rational expectations, a rule that responds to both productivity shocks and inflation expectations better stabilizes the economy but does not prevent agents from switching between heuristics. Finally, we study the impact of introducing an explicit inflation target, which can be used by agents as a simple heuristic, into an economy that did not previously have one. Depending on the heuristics agents have access to before the introduction of the target, this can result in reduced inflation volatility.

Why Don’t People Pay Attention? Endogenous Sticky Information in a DSGE Model

“…He finds that waves of optimism and pessimism regarding output can generate endogenous business cycles and a proportion of trend-extrapolators of inflation causes endogenous inertia in the simulated inflation series. Brazier et al (2008) allow for switching between adaptive and rational expectations of inflation in an OLG model and find that monetary policy should account for expected inflation in order to stabilize the economy. Even then, endogenous switching between heuristics causes endogenous volatility in the inflation rate, which can, however, be reduced when an inflation target heuristic is introduced successfully.…”

“…Note that the mechanism applies to both households and firms, as we assume that firms are owned by households, and that it governs the expectations of both inflation and excess demand. We follow the mechanism developed by Brock and Hommes (1997) that has also been employed, for instance, in De Grauwe (2008) and Brazier et al (2008). Discussion Paper L.Dräger tion and profits if the rational forecast produces a more accurate solution to the utility and profit optimization problems than forecasts under sticky information.…”

Conquering Credibility for Monetary Policy under Sticky Confidence

“…Meanwhile, Brazier, Harrison, King, and Yates (2008) develop a model in which agents use two heuristics to forecast inflation: one is based on one-period lagged inflation, the other on an inflation target announced by the central bank (which is the steadystate value of inflation). Agents switch between these heuristics based on an imperfect assessment of how each has performed in the past.…”

“…The authors find that, on average, the majority of agents use the inflation-target heuristic, even though there are times when everyone does, and times when no one does. While Brazier et al (2008) embed those two forecasting heuristics in a monetary overlapping-generations model and heuristic switching is described by a discrete choice model, in this paper a different pair of forecasting heuristics is embedded in a macroeconomic model featuring a monetary authority that conducts a bestreply monetary policy and private decision makers switch between heuristics based on evolutionary dynamics with and without exogenous perturbations analogous to mutations in a biological system. De Grauwe (2011) develops a macro model in which agents have cognitive limitations and use simple but biased heuristics to forecast future inflation.…”

“…De Grauwe (2011) develops a macro model in which agents have cognitive limitations and use simple but biased heuristics to forecast future inflation. The author follows Brazier et al (2008) in allowing for two inflation forecasting rules. One heuristic is based on the announced inflation target, while the other heuristic uses last period's inflation to forecast next period's inflation.…”