A Simple Model of Monetary Policy under Phillips-Curve Causal Disagreements

TL;DR

This paper introduces a static monetary policy model where the private sector's expectations are based on a misspecified causal model, revealing how causal disagreements influence optimal policy outcomes.

Contribution

It incorporates causal model disagreements into monetary policy analysis using Bayesian Networks, highlighting effects on policy sensitivity and inflation-output dynamics.

Findings

Private sector's causal model reverses inflation-output causality.

Optimal policy shows attenuation effects sensitive to model noise.

Disagreements impact inflation and output forecasts.

Abstract

I study a static textbook model of monetary policy and relax the conventional assumption that the private sector has rational expectations. Instead, the private sector forms inflation forecasts according to a misspecified subjective model that disagrees with the central bank's (true) model over the causal underpinnings of the Phillips Curve. Following the AI/Statistics literature on Bayesian Networks, I represent the private sector's model by a direct acyclic graph (DAG). I show that when the private sector's model reverses the direction of causality between inflation and output, the central bank's optimal policy can exhibit an attenuation effect that is sensitive to the noisiness of the true inflation-output equations.