Expectations and the Stability Problem for Optimal Monetary Policies,” Review of Economic Studies

A fundamentals based monetary policy rule, which would be the optimal monetary policy without commitment when private agents have perfectly rational expectations, is unstable if in fact these agents follow standard adaptive learning rules. This problem can be overcome if private expectations are observed and suitably incorporated into the policy makers optimal rule. These strong results extend to the case in which there is simultaneous learning by the policy maker and the private agents. Our Þndings show the importance of conditioning policy appropriately, not just on fundamentals, but also directly on observed household and Þrm expectations.