Survey_BC_2003

Abstract

We begin with a standard New Keynesian model as described by Woodford (1999, 2003) and Clarida, Gali, and Gertler (1999). We introduce learning into this economy, following the analysis of Bullard and Mitra (2002). We restrict attention to situations under which the targeted equilibrium of the central bank would be both determinate and learnable under their analysis. We then look for circumstances under which the stability under learning might break down, and cause the system to visit a low nominal interest rate, low inflation outcome, like the ones displayed in Figure 1.6 We use ‘large deviation’ theory as employed by Sargent (1999) and Cho, Williams, and Sargent (2002) to generate these departures, or “escapes.” We spend much of the paper documenting that the escape dynamics depend on three factors. These factors are (1) A certain misspecification on the part of the private sector regarding the actions of the policy authorities, (2) Feedback from the beliefs of the private sector to the actions of the policy authority, and (3) A learning rule that reflects the private sector’s doubt about the accuracy of their specification. We think these factors are plausibly at work in actual economies. During the middle-to-late 1980s, the Japanese economy was widely admired in the business press and among academics. It had grown rapidly for many years, and seemed to threaten U.S. world economic leadership. But Japanese success faded in the 1990s as the economy became mired in a cycle of poor performance. One of the features of the 1990s Japanese experience was a sharp decline in short-term nominal interest rates. Figure 1 shows annualized three-month unregulated time deposit rates in Japan from 1990 through 2000. These rates have remained below one percent per annum since 1995, after beginning the decade near four percent. The low nominal interest rates have been associated with low inflation rates. Consumer prices were rising at a rate of 3 to 4 percent per year in Japan at the beginning of the 1990s, but the inflation rate has fallen to between ±1 percent since 1995, when measured as a percent increase from the previous year (the exception is 1997, when it rose to about two percent). Real performance has been poor during the 1990s, especially when compared to earlier decades.