Must-Read: Barrel. Fish. Gun:
: Interest Rate Pegs in New Keynesian Models: “John Cochrane asks: Do higher interest rates raise or lower inflation?’…
…We find that pegging the interest rate at a higher level will induce instability and most likely lead to falling inflation and output over time. Eventually, this will precipitate a change of policy…
Must-Read: Via Mark Thoma: : The Neo-Fisherian View and the Macro Learning Approach: “[A] REE… needs an explanation for how economic agents come to coordinate on it…
…This point is acute in models in which there are multiple RE solutions…. The macro learning literature provides a theory for how agents might learn over time to forecast rationally… by updating their econometric forecasting models provided the REE satisfies ‘expectational stability’ (E-stability) conditions. If these conditions are not satisfied then convergence to the REE will not occur and hence it is implausible that agents would be able to coordinate on the REE…. For a wide range of models this gives plausible results… the basic Muth cobweb model… Lucas (1986) used an adaptive learning scheme to show that though the overlapping generations model of money has multiple REE, learning dynamics converge to the monetary steady state, not to the autarky solution. Early analytical adaptive learning results were obtained in Bray and Savin (1986) and the formal framework was greatly extended in Marcet and Sargent (1989). The book by Evans and Honkapohja (2001) develops the E-stability principle and includes many applications….
There are other approaches…. The ‘eductive’ approach of Guesnerie asks whether mental reasoning by hyper-rational agents, with common knowledge of the structure and of the rationality of other agents, will lead to coordination on an REE…. The Garcia-Schmidt and Woodford (2015) ‘reflective equilibrium’ concept… draws on both the adaptive and eductive strands as well as on the ‘calculation equilibrium’ learning model of Evans and Ramey (1992, 1995, 1998)…. The lack of a TE or learning framework in Cochrane (2011, 2015) is a critical omission…. In our… ‘Observability and Equilibrium Selection,’ Evans and McGough (2015b), we develop the theory of adaptive learning when fundamental shocks are unobservable…. Adaptive learning thus operates as a selection criterion and it singles out the usual RE solution adopted by proponents of the NK model. Furthermore, when monetary policy does not obey the Taylor principle, then neither of the solutions is robustly stable under learning; an interest-rate peg is an extreme form of such a policy, and the adaptive learning perspective cautions that this will lead to instability…. The learning approach argues forcefully against the neo- Fisherian view.