Abstract:
We propose a novel approach to modeling and conducting optimal monetary policy under heterogeneous beliefs between the central bank and the public concerning the structure of the economy.Given this heterogeneity in beliefs, we assert that the optimal monetary policy requires a central bank to model the expectations formation of the public and to combine it with its own structural model. This is because the public’s expectations affect the economy.This approach minimizes the welfare loss, as the central bank exploits the interrelations (contemporaneous and dynamic) among the economic variables which affect the public’s expectations. If the central bank does not account for this discrepancy in beliefs, but instead ignores the expectation formation mechanism of the public, it generates noticeable welfare losses.