Working Paper

Inflation expectations and the transmission of monetary policy

Abstract: New Keynesian models with sticky prices and rational expectations have a difficult time explaining why reducing inflation usually requires a recession. An explanation for the costliness of reducing inflation is that inflation expectations are less than perfectly rational. To explore this possibility, I estimate the degree of nonrationality implicit in two survey measures of inflation expectations. I find that the surveys reflect an intermediate degree of rationality: Expectations are nether perfectly rational nor as unsophisticated as simple autoregressive models would suggest. I also find that a structural New Keynesian model with expectations formation based on the survey results is able to match closely the empirical costs of reducing inflation.

Keywords: Inflation (Finance); Monetary policy;

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 1998

Number: 1998-43