June 2008 issue contents
The Danger of Inflating Expectations of Macroeconomic Stability: Heuristic Switching in an Overlapping-Generations Monetary Model

by Alex Brazier, Richard Harrison, Mervyn King, and Tony Yates
Bank of England


We use a monetary overlapping-generations model to discuss the cause and durability of the marked fall in the volatility of inflation in recent decades. In our model, agents have to forecast inflation, and they do so using two "heuristics." One is based on lagged inflation, the other on an inflation target announced by the central bank. Agents switch between those heuristics based on an imperfect assessment of how each has performed in the past. The way the economy propagates productivity shocks into inflation depends on the proportion of agents using each heuristic. Movements in these proportions generate fluctuations in small-sample measures of economic volatility. We use this simple model of heuristic switching to contrast the performance of monetary policy rules. We find that, relative to the rule that would be optimal under rational expectations, a rule that responds to both productivity shocks and inflation expectations better stabilizes the economy but does not prevent agents from switching between heuristics. Finally, we study the impact of introducing an explicit inflation target, which can be used by agents as a simple heuristic, into an economy that did not previously have one. Depending on the heuristics agents have access to before the introduction of the target, this can result in reduced inflation volatility.

JEL Codes: E32, E37, E52.

Full article (PDF, 36 pages 430 kb)