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MONETARY POLICY RULES UNDER HETEROGENEOUS INFLATION EXPECTATIONS

                                                             Sophocles N. Brissimis
                                               Bank of Greece and University of Piraeus

                                                               Nicholas S. Magginas
                                                            National Bank of Greece

ABSTRACT

This paper evaluates the role of inflation-forecast heterogeneity in US monetary policy making. The deviation between private and central bank inflation forecasts is identified as a factor increasing inflation persistence and thus calling for a policy reaction. An optimal policy rule is derived by the minimization under discretion of a standard central bank loss function subject to a Phillips curve, modified to include the forecast deviation, and a forward-looking aggregate demand equation. This rule, which itself includes the forecast deviation as an additional argument, is estimated for the period 1974-1998, covering the Chairmanships of Arthur Burns, Paul Volcker and Alan Greenspan, by using real-time forecasts of inflation and the output gap obtained from the FOMC’s Greenbook and the Survey of Professional Forecasters. The estimated rule remains remarkably stable over the whole sample period, challenging the conventional view of a structural break following Volcker’s appointment as Chairman of the Fed. Finally, the substantial decline in the significance of the interest-rate smoothing term in the rule indicates that monetary policy inertia may, to a large extent, be an artifact of serially correlated inflation-forecast errors that feed into policy decisions in real time.

Keywords: Forward-looking model; Monetary policy reaction function; Expectations formation; Inflation expectations

JEL classification: D84; E31; E43; E52; E58

Acknowledgements
We are grateful to Heather Gibson for helpful comments. The views expressed in this paper are of the authors and do not necessarily reflect those of their respective institutions.

Correspondence:

Sophocles N. Brissimis,
Economic Research Department,
Bank of Greece, 21 E. Venizelos Ave.,
102 50 Athens, Greece,
Tel. +30 210-320 2388
Fax: +30 210 320 2432
E-mail: sbrissimis@bankofgreece.gr


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