Working Paper No. 303
By Alex Brazier, Richard Harrison, Mervyn King and Tony Yates
The volatility of inflation and output has fallen in most advanced economies in the 1990s and 2000s. We use a monetary overlapping generations model to discuss the cause and durability of this macroeconomic change. In that model, agents' decision rules require them to make forecasts of future inflation, which, because of shocks to productivity, is uncertain. Agents make forecasts of inflation using two rules of thumb or 'heuristics'. One is based on lagged inflation, the other on an inflation target announced by the central bank. They switch between those heuristics based on an imperfect assessment of how each has performed in the past. The way the economy propagates productivity shocks into inflation depends on the proportion of agents using each. Movements in that proportion generate fluctuations in small sample measures of economic volatility. We use this simple model of heuristic switching to contrast the performance of monetary policy rules. We find that, relative to the rule that would be optimal under rational expectations, a rule that responds to both productivity shocks and inflation expectations better stabilises the economy but does not prevent agents switching between heuristics. Finally, we study the impact of introducing an explicit inflation target, which can be used by agents as a simple heuristic, into an economy that did not previously have one. Depending on the heuristics agents have access to before the introduction of the target, this can result in reduced inflation volatility.