By Kaushik Mitra, George Evans, and Seppo Honkapohja
What is the impact of surprise and anticipated policy changes when agents form expectations using adaptive learning rather than rational expectations? We examine this issue using the standard stochastic real business cycle model with lump-sum taxes. Agents combine knowledge about future policy with econometric forecasts of future wages and interest rates. Both permanent and temporary policy changes are analyzed. Dynamics under learning can have large impact effects and a gradual hump-shaped response, and tend to be prominently characterized by oscillations not present under rational expectations. These fluctuations reflect periods of excessive optimism or pessimism, followed by subsequent corrections.
When we analyze policy changes, we too often assume everybody knows immediately everything about the new policy. What if this is not the case? Political and policy uncertainties, as they are prevalent in several countries right now, make this question very relevant. This paper, by the leaders on the learning literature in macroeconomics, One highlight of the paper is that under adaptive learning responses to policy changes exhibit an hump shape. Another is that the impact of announced future policy changes can be more dramatic under adaptive learning than rational expectations, and it could even generate waves.