Expectations and optimal monetary policy: A stability problem revisited

- We examine the stability of equilibrium under adaptive learning.
- Agents have limited information and use simple linear forecasting rules.
- Both fundamental and expectations-based rules lead to stable equilibria.
- Multiple equilibria abound.
- Learning can be used as a selection tool to identify a unique equilibrium.

A landmark result in the optimal monetary policy design literature is that fundamental-based interest rate rules invariably lead to rational expectations equilibria (REE) that are not stable under adaptive learning. In this paper, we make a novel information assumption that private agents cannot observe aggregate fundamental shocks, and use simple linear forecasting rules for learning. We find that with fundamental-based rules, there exist limited information equilibria that are stable under learning. Moreover, there are multiple equilibria. Learning can be used as a selection tool to identify a unique equilibrium.