Seminar in Macroeconomics - Stefano Eusepi (University of Texas at Austin)
On the Limits of Monetary Policy
Tuesday 11 December 2018 (12h15 - 13h30) - Extranef - 109
This paper provides theory and evidence that distorted long-term interest-rate expectations represent a fundamental constraint on monetary policy design. Permitting beliefs to depart from those consistent with rational expectations equilibrium breaks the tight link between policy rates and long-term expectations, even when long-term interest rates are determined by the expectations hypothesis of the yield curve. Because bond prices are excessively sensitive to short-term interest rates, the central bank faces
an intertemporal trade-off which results in optimal policy being less aggressive relative to rational expectations. More aggressive policy leads to sub-optimal volatility in long-term interest rates and aggregate demand through standard intertemporal substitution effects. These effects are quantitatively important over the Great Inflation and Great Moderation periods of US monetary history.