Research

Keeping Control over Boundedly Rational Expectations

with Magali Marx

How can central banks avoid losing control over inflation expectations? Under rational expectations, respecting the Taylor principle is needed to ward off self-fulfilling inflation. We reconsider the issue away from rational expectations, for a class of boundedly rational expectations embedding cognitive discounting and long-term learning. (1) Self-fulfilling inflation is no longer a concern, but too passive a monetary policy leads to inflation spirals. (2) Active monetary policies can be characterized without restricting to Taylor rules, as those that sufficiently increase a weighted average of present and future policy rates. (3) The more the central bank cares about output stabilization, the more it should deliver the necessary tightening through expectations of future hikes instead of current hikes.

Putting the I Back in the IS Curve

How do interest rates affect aggregate consumption? The recent literature on household heterogeneity has revived the importance of the Keynesian cross, which amplifies the initial reaction of consumption to interest rate changes through high MPCs. Yet this channel still originates in households' intertemporal substitution. This paper shows how, once it is combined with investment, household heterogeneity creates a new channel that works entirely away from intertemporal substitution. High MPCs are not enough. The channel relies on an interaction between heterogeneity in MPCs and heterogeneity in the share of labor income in household incomes.