Adaptive learning and the use of forecasts in monetary policy

This paper investigates monetary policy design when central bank and private-sector expectations differ. Private agents learn adaptively: the central bank has a possibly misspecified model of the economy. Successful implementation of optimal policy using inflation targeting rules requires the central bank to have complete knowledge of private agents' learning behavior. If the central bank mistakenly assumes private agents to have rational expectations when in fact they are learning, then policy rules frequently lead to divergent learning dynamics. However, if the central bank does not correctly understand agents' behavior, stabilization policy is best implemented by controlling the path of the price level rather than the inflation rate. (C) 2008 Elsevier B.V. All rights reserved