January 2020

Short-term Planning, Monetary Policy, and Macroeconomic Persistence

Christopher Gust, Edward Herbst, and David López-Salido

Abstract:

This paper uses aggregate data to estimate and evaluate a behavioral New Keynesian (NK) model in which households and firms plan over a finite horizon. The finite-horizon (FH) model outperforms rational expectations versions of the NK model commonly used in empirical applications as well as other behavioral NK models. The better fit of the FH model reflects that it can induce slow-moving trends in key endogenous variables which deliver substantial persistence in output and inflation dynamics. In the FH model, households and firms are forward-looking in thinking about events over their planning horizon but are backward looking regarding events beyond that point. This gives rise to persistence without resorting to additional features such as habit persistence and price contracts indexed to lagged inflation. The parameter estimates imply that the planning horizons of most households and firms are less than two years which considerably dampens the effects of expected fut ure changes of monetary policy on the macroeconomy.
 

Keywords: Finite-horizon planning, learning, monetary policy, New Keynesian model, Bayesian estimation.

DOI: https://doi.org/10.17016/FEDS.2020.003

PDF: Full Paper

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Last Update: January 09, 2020