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Revised November 12, 2003
We show diversity of beliefs is an important propagation mechanism of fluctuations, money non neutrality and the
efficacy of monetary policy. In a competitive model with flexible prices in which agents hold Rational Belief (see
Kurz (1994)) we show:
(i) Our economy replicates well the empirical record of fluctuations in the U.S.
(ii) Under
a simple monetary rule without discretion, aggressive anti-inflationary rule can bring inflation volatility down to
zero. Stabilization instrument can reduce consumption volatility by some 55% at substantial cost of inflation
volatility. To avoid total instability, inflation and output stabilization instruments must be used together.
(iii) The
Phillips Curve changes substantially with policy instruments. Activist monetary policy eliminates the Phillips
Curve and renders it vertical.
(iv) Although prices are flexible, money shocks result in less than a proportional
changes in inflation hence the aggregate price level appears �sticky� with respect to money shocks.
(v) Discretion
in monetary policy has an impact on the efficacy of policy depending upon the revision of beliefs induced by
central bank discretionary decisions. We study two rationalizable economies. In one market beliefs weaken the
effect of policy, discretion has a harmful effect on policy outcomes thus an optimal policy should avoid discretion.
In the second, beliefs bolster policy outcomes and discretion is a desirable attribute of the policy rule. Some
evidence suggests the structure of market beliefs is closer to the first type, hence avoiding discretion is an optimal
central bank policy.
(vi) An implication of our model suggests that the current effective policy is not activist and
aims mostly to target inflation only.