Animal spirits and optimal monetary policy design in the presence of labour market frictions

Using a New Keynesian DSGE model with labour market frictions, we compare outcomes for backward-looking animal spirits expectations with rational expectations after technology and demand shocks. For optimal monetary policy, major differences arise only for technology shocks, and discretionary policy...

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Bibliographic Details
Published in:Economic modelling 2016-01, Vol.52, p.898-912
Main Authors: Sheen, Jeffrey, Wang, Ben Zhe
Format: Article
Language:English
Subjects:
Comparative studies
Economic activity
Investor behavior
Keynesian theory
Labor market
Monetary policy
Rational expectations
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Summary:Using a New Keynesian DSGE model with labour market frictions, we compare outcomes for backward-looking animal spirits expectations with rational expectations after technology and demand shocks. For optimal monetary policy, major differences arise only for technology shocks, and discretionary policy performs better than commitment policy under animal spirits expectations. If Taylor rule parameters are chosen to best replicate optimal monetary policy outcomes, inflation targeting is only appropriate for technology shocks, particularly for large labour frictions, while targeting only economic activity is appropriate for demand shocks. Fault tolerance analysis shows high costs from failing to identify true animal spirits expectations and technology shocks. •We evaluate the impact of animal spirits expectation on monetary policy.•We find discretionary is better than commitment policy if animal spirits are present.•Mis-identifying animal spirits expectations and technology shocks incur large costs.
ISSN:0264-9993
1873-6122
DOI:10.1016/j.econmod.2015.10.028