New Keynesian Model Dynamics under Heterogeneous Expectations and Adaptive Learning

We analyze the economic dynamics in a basic New Keynesian model adjusted for imperfect, heterogeneous knowledge and adaptive learning. The policy, represented by a forward-looking Taylor rule, is driven by the central bank's own internal forecasts, whereas the core economic dynamics are driven by private agents' expectations. We study the implications of disagreement between those two. We find that if there is expectations heterogeneity, monetary policy should be less active in its actions in order to be short-run stability improving, and to affect positively the speed of convergence towards the first best equilibrium in the long run. This is in contrast to the homogeneous incomplete knowledge literature, which predicts the opposite. We also find that the homogeneous expectations economy is easier to operate in for monetary policy, and that policy can be more effective than in the heterogeneous expectations economy. From the perspective of incomplete, heterogeneous knowledge and adaptive learning methodology, we can thus see the importance of good communication policy and monetary policy credibility.