Inflation Expectations and Monetary Policy

This paper shows that an economy’s behavior differs significantly according to assumptions made on the formation of inflation expectations. We analyzed the behavior of an open economy in a regime of explicit inflation targeting with commitment. The economy is exposed to three different shocks – demand, supply, and exchange rate – and its reaction is analyzed under three different assumptions on inflation-expectations formation: naive, rational, and adaptive learning. The economy in which rational expectations were assumed showed the least volatile development and minimized the central bank’s loss function. The stabilizing effect of this forward-looking type of expectation was most evident in the case of supply shock. When naive expectations were assumed, the economy reacted to all shocks with significantly bigger and longer-lasting fluctuations. The worst results were obtained assuming adaptive-learning expectations, where shocks lead to large oscillations and the economy stabilized only several years after the shock.