Learning, Inflation Reduction and Optimal Monetary Policy

In this paper, we analyze disinflation in two environments. One in which the central bank has perfect knowledge, in the sense that it understands and observes the process by which private sector inflation expectations are generated, and one in which the central bank has to learn the private sector inflation forecasting rule. Here, the learning scheme we investigate is that of least-squares learning (recursive OLS) using the Kalman filter. With imperfect knowledge, results depend on the learning scheme that is employed. A novel feature of the passive learning policy - compared to the central bank's disinflation policy under perfect knowledge - is that the degree of monetary accommodation (the extent to which the central bank accommodates private sector inflation expectations) is no longer constant across the disinflation, but becomes state-dependent. This means that the central bank's behaviour changes during the disinflation as it collects more information