Abstract: We investigate the implications of rule-of-thumb behaviour on the part of
consumers or price setters for optimal monetary policy and simple interest
rate rules. The existence of such behaviour leads to endogenous persistence
in output and inflation; changes the transmission of shocks to these
variables; and alters the policymaker's welfare objective. Our main
finding is that highly inertial policy is optimal regardless of what
fraction of agents occasionally follow a rule of thumb. We also find that
the interest rate rule that implements optimal policy in the purely optimising
case, and a first-difference version of Taylor's (1993) rule, have desirable
properties in all of the cases we consider. By contrast, the coefficients in
other optimised simple rules tend to be extremely sensitive with respect to
the fraction of rule-of-thumb behaviour and changes in other parameters of the
model.
Keywords: Rule of thumb, optimal monetary policy, interest rate rules
Full paper (505 KB PDF)
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Last update: January 28, 2002
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