Abstract
This thesis consists of two independent chapters on monetary policy.
Chapter 1 examines the role of house price expectations in influencing the inflation expectations of households. This work is motivated by the role of salience of large changes in determining inflation expectations of households. We use two survey datasets for the United States which report quantitative expectations for both inflation and house prices. We find that households tend to overweight house price expectations when forming their inflation expectations, relative to an `accounting' benchmark. Examining cross-sectional heterogeneity in the data reveals a significant effect of the cognitive abilities of households as more sophisticated households don’t overweight house price inflation as much. We model this household behaviour in a two-sector New Keynesian model, with an overweighted and a non-overweighted sector, and analytically derive a welfare loss function consistent with the micro-foundations of the model. In this setup, we show that to gauge the correct interest rate response, it is imperative for the central bank to be aware that some sectors are overweighted by consumers and that movements in expected inflation in such sectors are important for optimal monetary policy.
The contribution of this chapter is twofold. First, we find a novel channel of salience through house price expectations; this makes a case for the central bank to monitor the housing sector beyond the usual, very important, financial stability concerns. Second, the paper breaks new ground by presenting a simple model that applies more generally to understand the monetary policy implications of over-weighting in any good. This provides a framework that can be adapted to analyse some findings from the previous literature.
Chapter 2 examines the implications of the central bank's dual mandate of price stability and economic growth in a Tractable Heterogenous Agent New Keynesian economy where nominal taxes adjust to ensure that the government budget constraint is satisfied for any price level. The model allows for agent heterogeneity, incomplete markets, positive liquidity and fiscal policy to be set in nominal terms. We analyse the stability of the model under both price-level Wicksellian and inflation-targeting Taylor rules, allowing for a dual mandate. We show analytically that local price level determinacy is not retained if the central bank aims to stabilize both inflation and output. This is because a positive response to economic activity in the Taylor rule leads to instability, and we find that this is due to the evolution of government spending. In the absence of a response to output in the Taylor rule, government spending acts as an automatic stabilizer. This instability does not arise when the central bank targets the price level instead due to the history-dependence property of price-level rules. This result implies that central banks with a dual mandate should use a Wicksellian rule, and thus makes a case for price-level targeting.
While the dual mandate has become the cornerstone of monetary policy, price stability, in principle, could be achieved either by targeting inflation or targeting the price level. Which of the two is desirable remains an open question. Our work contributes to this debate by showing the compatibility of price-level targeting with the central bank’s dual mandate.