Monetary Policy during a Transition to Rational Expectations

In standard macroeconomic models incorporating the natural rate hypothesis and rational expectations, monetary policy has no effect on real variables. But the rational expectations assumption that economic agents have learned from their mistaken predictions of the past ignores the transition period during which new information is combined with old information in the formation of new beliefs. The purpose of this paper is to examine the possible effects of monetary policy during this transi- tion period. Using a simple momentary Phillips curve model and a particular characterization of monetary policy, it is shown that real variables (in this case unemployment) can be controlled. Further, an optimal monetary policy is computed by simple variational methods. This policy is a randomized rule which matches the marginal gain from future reductions in unemployment to the marginal loss of increased uncertainty about the price level. Unlike the rational expectations equilibrium, this rule will dominate purely deterministic rules, even if the latter are possible.