Optimal Monetary Policy Under Bounded Rationality

IMF Working Papers, August 2, 2019

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The form of bounded rationality characterizing the representative agent is key in the choice of the optimal monetary policy regime.
Inflation targeting prevails as optimal when myopia distorts agents' inflation expectations.
Price level targeting emerges as the optimal policy when myopia concerns the output gap, revenue, or interest rate.
To the extent that bygones are not bygones under price level targeting, rational inflation expectations is a minimal condition for optimality in a behavioral world.
Implementation of the optimal policy via instrument rules is shown to be infeasible, calling into question the usefulness of simple rules à la Taylor (1993) for assisting the conduct of monetary policy.
Bounded rationality is not necessarily associated with welfare losses.

Prefer inflation targeting when agents' myopia primarily affects inflation expectations.
Prefer price level targeting when agents' myopia primarily affects perceptions of the output gap, revenue, or interest rate.
Ensure that inflation expectations are rational (or sufficiently well-anchored) if adopting price level targeting, because bygones not being bygones under price level targets makes rational inflation expectations a minimal condition for optimality.
Be cautious about relying on simple instrument rules (e.g., Taylor-style rules) to implement optimal policy in environments with boundedly rational agents, since instrument-rule implementation can be infeasible.

The analysis links the optimal monetary regime directly to the specific form of bounded rationality present in agents.
The infeasibility of instrument rules suggests central banks may need more flexible or state-contingent policy frameworks when facing behavioral frictions.
Welfare outcomes under bounded rationality are ambiguous: bounded rationality does not automatically imply welfare losses.

Subject: Banking, Inflation, Neoclassical theory, Output gap, Real interest rates
Keywords: central bank, monetary policy, WP

Source: IMF Working Paper "Optimal Monetary Policy Under Bounded Rationality" by Jonathan Benchimol and Lahcen Bounader (August 2, 2019).