Coevolution of expectations and monetary policy in a simple Kydland & Prescott economy

With Jasmina Arifovic

Abstract: We study learning in the Kydland and Prescott environment. Our policy maker evaluates its potential strategies regarding the announced and the actual inflation rate using its mental model. This model is forward looking and adaptive at the same time. There are two types of agents: Believers who set their inflation forecast equal to the announced inflation, and nonbelievers who form static optimal forecast coupled with a forecast error correction mechanism. Our results show that the economy can reach near Ramsey outcomes most of the time. In the absence of believers, the economies almost always converge to the Ramsey outcome. In their experiments with human subjects, Arifovic and Sargent (2003) showed that experimental economies reach and stay close to the Ramsey outcome most of the time, giving support to the "just do it" policy recommendation. In light of the experimental findings, our model is of particular interest as it is the only agent-based or adaptive learning model that consistently selects the Ramsey outcome.