ADAPTIVE LEARNING AND MONETARY POLICY IN AN OPEN ECONOMY: LESSONS FROM JAPAN

Motivated by Japan's economic experiences in recent decades, we incorporate adaptive learning into an open economy dynamic stochastic general equilibrium model to examine the volatility and welfare impact of alternative monetary policies. Comparing four Taylor-styled policy rules that reflect Japan's monetary policy debates, we first show that imperfect knowledge and the associated learning process induce higher volatility in the economy and that explicit exchange rate stabilization is unwarranted. Moreover, contrary to results under the rational expectation paradigm, we find that while tight inflation controls raise output volatility, they can improve overall welfare under learning by smoothing inflation fluctuations. Copyright 2008 The Authors. Journal compilation 2008 Blackwell Publishing Asia Pty Ltd