Modeling diverse expectations in an aggregated New Keynesian Model

Modecai Kurz, Giulia Piccillo, Howei Wu

Research output: Contribution to journalArticleAcademicpeer-review

Abstract

We explore a New Keynesian Model with diverse beliefs and study the aggregation problems in the log-linearized economy. We show the solution of these problems depend upon the belief structure. Agents' beliefs are described by individual state variables and satisfy three Rationality Axioms, leading to the emergence of an aggregate state variable named “mean market state of belief.” In equilibrium, endogenous variables are functions of mean market belief and this state variable is the tool used to solve the aggregation problems.

Diverse beliefs alter the problem faced by a central bank since the source of fluctuations is not only exogenous shocks but also market expectations. Due to diverse beliefs the effects of policy instruments are not monotonic and the trade-off between inflation and output volatilities is complex. Also, monetary policy can counter the effects of market belief by aggressive anti-inflation policy but at the cost of increased volatility of financial markets and individual consumption.
Original languageEnglish
Pages (from-to)1403-1433
JournalJournal of Economic Dynamics & Control
Volume37
Issue number8
DOIs
Publication statusPublished - 2013
Externally publishedYes

JEL classifications

  • c53 - "Forecasting and Prediction Methods; Simulation Methods "
  • d80 - Information, Knowledge, and Uncertainty: General
  • d84 - "Expectations; Speculations"
  • e27 - Macroeconomics: Consumption, Saving, Production, Employment, and Investment: Forecasting and Simulation: Models and Applications
  • e42 - "Monetary Systems; Standards; Regimes; Government and the Monetary System; Payment Systems"
  • e52 - Monetary Policy
  • g12 - "Asset Pricing; Trading volume; Bond Interest Rates"
  • g14 - "Information and Market Efficiency; Event Studies"

Keywords

  • New Keynesian Model
  • Heterogenous beliefs
  • market state of belief
  • Bayesian learning
  • updating beliefs
  • rational beliefs
  • monetary policy rule

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