Optimal monetary policy with subjective beliefs

The efficacy of monetary policy is significantly influenced by how individual consumers form their inflation expectations. Traditional economic models often assume agents have full awareness and responsiveness, aligning with the full-information rational expectations (FIRE) framework. However, empirical evidence indicates limited support for FIRE and highlights considerable heterogeneity in consumers’ subjective beliefs. Factors such as exposure to daily prices and inflation history can impact consumers’ views on future inflation, leading to diverse responsiveness and accuracy in inflation predictions. Therefore, it is vital to consider the interaction between expectation heterogeneity and marginal propensities to consume when assessing monetary policy effects.

This project begins by investigating how expectation formation depends on individual characteristics like income and age. We opt for the Michigan Survey of Consumers (MSC) and Survey of Consumer Expectations (SCE) over the Survey of Professional Forecasters (SPF), focusing on the general public’s expectation formation. We aim to document the following aspects of inflation expectation: (1) the degree to which different consumer groups under-react or over-react to economic condition changes unconditionally; (2) the conditional dynamic responses of beliefs in different subgroups to identified economic shocks such as monetary policy shocks or Total Factor Productivity (TFP) shocks.

The project’s second part intends to examine the optimal monetary policy in light of the documented heterogeneity in consumers’ expectation formation. We will incorporate heterogeneous income with diverse subjective beliefs. The model can be further extended to include an overlapping generation structure to directly address age effects on inflation expectations. The design of optimal monetary policy will depend on this interaction between imperfect expectations and income heterogeneity.