Leaning against the wind in the New Keynesian model with heterogeneous expectations

Abstract

In this paper, we explore the efficiency of the Leaning Against the Wind (LAW) policy within the New Keynesian framework with heterogeneous expectations. To do this, we add a financial sector to the model, linking it with the real sector via the financial accelerator channel. We find that the range of parameters in the Taylor rule that enable the stability of the targeted equilibrium is reduced with the financial accelerator. However, expanding the Taylor rule via the LAW policy fails to counteract this effect and may even exacerbate it if the policy reacts to any mispricing. If applied conditionally on high mispricing, the LAW policy leads to co-existing stable targeted and non-targeted equilibria. Our simulations suggest that while the LAW policy can reduce the amplitude of endogenous fluctuations, it is inefficient in dealing with exogenous shocks and results in larger average deviations from the target.