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Title: Should central banks be forward-looking?

Author(s): Paul De Grauwe and Yuemei Ji

Publication Date: March 2020

Keyword(s): animal spirits, behavioural macroeconomics and Taylor rule

Programme Area(s): Monetary Economics and Fluctuations

Abstract: We show that in a world where agents have limited cognitive abilities and, as a result, are prevented from having rational expectations the answer to this question is negative. We find that in "tranquil periods" when market sentiments (animal spirits) are neutral a forward-looking Taylor rule produces similar results as current-looking Taylor rule in terms of output and inflation volatility. However, when the economy is in a regime of booms and bust produced by extreme values of animal spirits the forward-looking central bank will make many policy errors that have to be corrected afterwards. Thus in a regime of extreme uncertainty the use of a forward Taylor rule reduces the quality of policy-making, leading to greater variability of the output and inflation. It is then better for the central bank to use currently observed output and inflation to set the interest rate. The empirical evidence suggests that central banks are often not forward looking. Our model provides the theoretical justification for this.

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Bibliographic Reference

De Grauwe, P and Ji, Y. 2020. 'Should central banks be forward-looking?'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=14540