On the Determinacy of Monetary Policy under Expectational Errors

Forward looking agents with expectational errors provide a problem for monetary policy. We show that under such conditions a standard interest rate rule may not achieve determinacy. We suggest a modification to the standard policy rule that guarantees determinacy in this setting, which involves the policy maker co-ordinating inflation dynamics by responding to each of past, current and expected inflation. We show that this solution maps directly into Woodford’s (2000) timeless perspective. We trace the responses in an artificial economy and illustrate the extent to which macroeconomic persistence is reduced following the adoption of this rule.