Ina Hajdini, ’21

How should the central bank conduct monetary policy in the presence of agents with bounded rationality under a policy regime switch?

One of the strongest assumptions we impose in our macroeconomic models is full rationality of any economic agent, meaning that we are all assumed to have perfect knowledge about the underlying structure of the economy. However, this might be a utopian assumption to make. In my research, I allow agents to have a perception of the economy structure that is slightly different from the real one as long as what they perceive is confirmed by data. This idea is then applied in a monetary policy regime switching framework: for example, it is well-documented that when Miller was substituted as a Fed chair by Volcker, there was a dramatic change in the monetary ruling as well. Preliminary results show that macro variables exhibit excessive persistence as compared to a model when agents are fully knowledgeable of the economy. Such results might be able to explain the extended periods of deflation in Japan, or hyperinflationary episodes in the Latin American countries.

Identifying the type of agents in the economy is important to policy makers, especially those working in the central banks. The reason why is that the implied dynamics of important macroeconomic variables, such as inflation or GDP, are highly dependent on the level of the agents’ rationality. Once the central authority understands that consumers and firms have bounded rationality, it can conduct policy in a way that the dynamics are not radically disrupted by the lack of rationality.