## Optimal Monetary Policy Under Bounded Rationality

_IMF Working Papers, August 2, 2019_

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## Bibliographic details
- Authors: Jonathan Benchimol, Lahcen Bounader
- Published: August 2, 2019
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781498324588.001

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### Authors and publication
- By Jonathan Benchimol, Lahcen Bounader
- August 2, 2019
- IMF Working Paper No. 2019/166
- Pages: 52
- Volume: 2019
- Issue: 166
- DOI: https://doi.org/10.5089/9781498324588.001
- Stock No: WPIEA2019166
- ISBN: 9781498324588
- ISSN: 1018-5941

### Core findings
- 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.

### Policy implications and recommendations
- 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.

### Theoretical and practical considerations
- 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 classification and keywords
- 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).*

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_Source: https://www.imf.org/en/publications/wp/issues/2019/08/02/optimal-monetary-policy-under-bounded-rationality-47048_