SEMINAR: Economics Research Seminar

Abstract - In a Cagan-type model of inflation we investigate how announcements of forward guidance may help lower inflation persistence. An important component of the model is heterogenous expectation formation - while market participants consider a time series model that uses sample autocorrelation learning, the Central Bank uses least squares learning of the MSV solution. Under certain parameter settings a high and low persistence equilibrium exist. We find that while active monetary policy does reduce the amount of time spent near the high persistence equilibrium, it is not enough to ensure that only the low persistence equilibrium obtains. Forward guidance in the form of announcements of future economic conditions, on the other hand, eliminates the possibility of a high inflation equilibrium. The intuition behind this result is that forward guidance can shock agents expectations in a way that overcomes the pull of persistence.