Aggressive Monetary Policy and Inflation Persistence : An Adaptive Learning Approach

We investigate the effectiveness of an aggressive anti-inflation monetary policy on the ability of agents to achieve rational expectations equilibrium (REE) forecasts of inflation. An aggressive anti-inflation policy includes a willingness to respond more forcefully to deviations from an inflation target. Using an adaptive learning framework, we develop a model that uses a real contracting rigidity in conjunction with an interest rate rule and an IS curve. The model equilibrium indicates that only an aggressive anti-inflation policy enables agents to learn the REE inflation forecast. The model also shows that inflation persistence (volatility) has a negative relation with policy aggressiveness. Empirical tests confirm this negative relation but these tests also indicate there is a lag between aggressive policy shifts and effective changes in inflation persistence (volatility)