Learning about monetary policy rules when the cost-channel matters

Abstract

We study how monetary policy may affect determinacy and expectational stability (E-stability) of rational expectations equilibrium when the cost channel of monetary policy matters. Focusing on instrumental Taylor-type rules and optimal target rules, we show that standard policies can induce indeterminacy and expectational instability when the cost channel is present. A naïve application of the traditional Taylor principle could be misleading, and expectations-based reaction function under discretion does not always induce determinate and E-stable equilibrium. This result contrasts with the findings of Bullard and Mitra [2002. Learning about monetary policy rules. Journal of Monetary Economics 49, 1105-1129] and Evans and Honkapohja [2003. Expectations and stability problem for optimal monetary policies. Review of Economic Studies 70, 807-824] for the standard new Keynesian model. The ability of the central bank to commit to an optimal policy is an antidote to these problems.