Inflation Targeting and Macroeconomic Stability with Heterogeneous Inflation Expectations

Abstract:

Drawing on an extensive empirical literature that suggests persistent and time-varying heterogeneity in inflation expectations, this paper embeds two inflation forecasting heuristics–one based on the current rate of inflation, and the second anchored to the official inflation target–in a simple macrodynamic model. Decision makers switch between these forecasting heuristics based on satisficing evolutionary dynamics. We show that convergence toward an equilibrium consistent with the level of output and rate of inflation targeted by policymakers is achieved regardless of whether or not the satisficing evolutionary dynamics that guide the choices agents make between inflation forecasting strategies are subject to noise. We also show that full credulity–a situation where all agents eventually use the forecasting heuristic based on the target rate of inflation–is neither a necessary condition for realization of the inflation target nor an inevitable consequence of the economy’s achievement of this target. These results demonstrate that uncertainty in decision making resulting in norm-based inflation expectations that are both heterogeneous and time-varying need not thwart the successful conduct of macroeconomic policy.

Key Words::

• inflation target
• macroeconomic stability
• heterogeneous expected inflation
• satisficing evolutionary dynamics

Additional information

Notes on contributors

Gilberto Tadeu Lima

Gilberto Tadeu Lima is a professor of economics in the Department of Economics at the University of São Paulo, Brazil. Mark Setterfield is a professor of economics in the Department of Economics at the New School for Social Research and the Dana Research and Maloney Family Distinguished Professor of Economics in the Department of Economics at Trinity College, Hartford, Connecticut. Jaylson Jair da Silveira is an associate professor in the Department of Economics and International Relations at the Federal University of Santa Catarina, Brazil. Earlier versions of this paper were presented at the First International Conference of the Herbert Simon Society, “Bounded Rationality Updated,” New York City, April 8–10, 2013, and at the Meetings of the Eastern Economic Association, Boston, March 6–9, 2014. The authors are grateful to conference participants and an anonymous referee of this journal for their helpful comments. Any remaining errors are our own. Gilberto Tadeu Lima and Jayson Jair da Silveira are also grateful to CNPq (Brazil) for providing research funding. Jayson Jair da Silveira gratefully acknowledges the Department of Economics of the University of Massachusetts Amherst, whose hospitality assisted his work on the completion of this paper, and the CAPES Foundation, Ministry of Education of Brazil, for the grant (Proc. BEX 18175/12-0) that funded his visit to UMass-Amherst.

Mark Setterfield

Gilberto Tadeu Lima is a professor of economics in the Department of Economics at the University of São Paulo, Brazil. Mark Setterfield is a professor of economics in the Department of Economics at the New School for Social Research and the Dana Research and Maloney Family Distinguished Professor of Economics in the Department of Economics at Trinity College, Hartford, Connecticut. Jaylson Jair da Silveira is an associate professor in the Department of Economics and International Relations at the Federal University of Santa Catarina, Brazil. Earlier versions of this paper were presented at the First International Conference of the Herbert Simon Society, “Bounded Rationality Updated,” New York City, April 8–10, 2013, and at the Meetings of the Eastern Economic Association, Boston, March 6–9, 2014. The authors are grateful to conference participants and an anonymous referee of this journal for their helpful comments. Any remaining errors are our own. Gilberto Tadeu Lima and Jayson Jair da Silveira are also grateful to CNPq (Brazil) for providing research funding. Jayson Jair da Silveira gratefully acknowledges the Department of Economics of the University of Massachusetts Amherst, whose hospitality assisted his work on the completion of this paper, and the CAPES Foundation, Ministry of Education of Brazil, for the grant (Proc. BEX 18175/12-0) that funded his visit to UMass-Amherst.

Jaylson Jair da Silveira

Gilberto Tadeu Lima is a professor of economics in the Department of Economics at the University of São Paulo, Brazil. Mark Setterfield is a professor of economics in the Department of Economics at the New School for Social Research and the Dana Research and Maloney Family Distinguished Professor of Economics in the Department of Economics at Trinity College, Hartford, Connecticut. Jaylson Jair da Silveira is an associate professor in the Department of Economics and International Relations at the Federal University of Santa Catarina, Brazil. Earlier versions of this paper were presented at the First International Conference of the Herbert Simon Society, “Bounded Rationality Updated,” New York City, April 8–10, 2013, and at the Meetings of the Eastern Economic Association, Boston, March 6–9, 2014. The authors are grateful to conference participants and an anonymous referee of this journal for their helpful comments. Any remaining errors are our own. Gilberto Tadeu Lima and Jayson Jair da Silveira are also grateful to CNPq (Brazil) for providing research funding. Jayson Jair da Silveira gratefully acknowledges the Department of Economics of the University of Massachusetts Amherst, whose hospitality assisted his work on the completion of this paper, and the CAPES Foundation, Ministry of Education of Brazil, for the grant (Proc. BEX 18175/12-0) that funded his visit to UMass-Amherst.