How Do Adaptive Learning Expectations Rationalize Stronger Monetary Policy Response in Brazil?

HowDoAdaptiveLearningExpectationsRationalizeStrongerMonetaryPolicyResponseinBrazil? AllanGloeDizioli,HouWang WP/23/19 IMFWorkingPapersdescriberesearchinprogressbytheauthor(s)andarepublishedtoelicitcommentsandtoencouragedebate. TheviewsexpressedinIMFWorkingPapersarethoseoftheauthor(s)anddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement. 2023 JAN ©2023InternationalMonetaryFundWP/23/19 IMFWorkingPaper ResearchDepartment HowDoAdaptiveLearningExpectationsRationalizeStrongerMonetaryPolicyResponseinBrazil? PreparedbyAllanGloeDizioliandHouWang* AuthorizedfordistributionbyRafaelPortilloJanuary2023 IMFWorkingPapersdescriberesearchinprogressbytheauthor(s)andarepublishedtoelicitcommentsandtoencouragedebate.TheviewsexpressedinIMFWorkingPapersarethoseoftheauthor(s)anddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement. ABSTRACT:ThispaperestimatesastandardDynamicStochasticGeneralEquilibrium(DSGE)modelthatincludesawageandpricePhillip'scurveswithdifferentexpectationformationprocessesforBrazilandtheUSA.Otherthanthestandardrationalexpectationprocess,wealsousealimitedrationalityprocess,theadaptivelearningmodel.Inthiscontext,weshowthattheseparateinclusionofalabormarketinthemodelhelpstoanchorinflationeveninasituationofadaptiveexpectations,apositiveoutputgapandinflationabovetarget.TheestimationresultsshowthattheadaptivelearningmodeldoesabetterjobinfittingthedatainbothBrazilandtheUSA.Inaddition,theestimationshowsthatexpectationsaremorebackward-lookingandstartedtodriftawaysoonerin2021inBrazilthanintheUSA.Wethenconductoptimalpolicyexercisesthatprescribeearlymonetarypolicytighteninginthecontextofpositiveoutputgapsandinflationfarabovethecentralbanktarget. RECOMMENDEDCITATION:Dizioli,Allan,HouWang,2023,“HowDoAdaptiveLearningExpectationsRationalizeStrongerMonetaryPolicyResponseinBrazil?”,IMFWorkingPapers JELClassificationNumbers: E2,E30,E52,E37,J6 Keywords: DSGE;Inflationdynamics;optimalmonetarypolicy;ForecastingandSimulation;Bayesianestimation. Author’sE-MailAddress: adizioli@imf.org,HWang2@imf.org *1InternationalMonetaryFundResearchDepartment.70019thStNW,Washington,DC20431,USA.Correspondingauthoris[]. IMFWORKINGPAPERSWage-PriceSpirals:WhatistheHistoricalEvidence? WORKINGPAPERS HowdoadaptivelearningexpectationsrationalizestrongermonetarypolicyresponseinBrazil? PreparedbyAllanGloeDizioliandHouWang1 1WethankRafaelPortillo,MatteoGhilardi,RomainBouis,WoonGyuChoiandPierreGuerinfortheirusefulcomments.TheviewsexpressedinthisWorkingPapersarethoseoftheauthorsanddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement. INTERNATIONALMONETARYFUND3 ContentsPage I.Introduction4 II.LiteratureReview6 III.Modelenvironment8 A.Workhorsemodel8 B.Expectationformationprocesses10 IV.DataandModelEstimation12 A.Data12 B.Modelfit15 V.Modelsimulationresults16 A.ComparisonoftheestimationresultsforBrazilandtheUSA16 B.Adaptivelearningexpectationscouldincreasethecostofstabilization18 C.Optimalmonetarypolicydiscussion22 VI.Conclusions23 References26 Tables 1.PriorDistributionoftheEstimatedParameters14 2.PosteriorEstimatesforREandALModels15 3.In-SampleForecastPerformanceforREandALModels15 4.Out-of-SampleForecastPerformanceforREandALModels16 Figures 1.Brazil:Lowwageworkerssufferedlargeremploymentlosses13 2.Realcomposition-constantwagesdidnotincreaseasmuch14 3.Brazil:Shockdecomposition18 4.USA:Shockdecomposition19 5.InflationandwagesexpectationsrespondtopastvaluesbymoreinBrazil20 6.Impulseresponsefunctionsforspecificshocks20 7.Impulseresponsefunctionsforspecificshocks21 8.Inflationisstickierwhenexpectationsareadaptivelearning22 9.Thecentralbankshouldfront-loadtighteningandthenease24 I.Introduction Aftertheintroductionofinflationtargetingregimesinmanycountriesaroundtheworld,therewasasensethatarelativelystableinflationandwell-anchoredinflationexpectations("thegreatmoderation")wouldbethenewnormalinmostcountries.Thepandemicshockand itsrepercussionsaccompaniedasurgeinglobalinflationnotseensincethe1980s.Asinfla-tionspikedandremainedhighforseveralmonths,inflationexpectationsalsostartedtodrifthigher.Inthiscontext,abetterunderstandingofinflationdynamicsandtheimplicationformonetarypolicyispressingatthecurrentjuncture. AnotherinterestingdevelopmentpresentedinthesecondyearofthepandemicwastheearlierresponsesfromEMcentralbankstothebadinflationnews.Isthereanyparticularfeaturetotheseeconomiesthatjustifiesthisearlierresponse?Whatkindofroledoexpectationforma-tionprocessesplayinshapingthesedecisions?Weexplorethesequestionsthroughthelensofacanonicaleconomicmodeloffirmpricesettingandlabormarketsunderdifferentexpecta-tionformationprocesses. Mostofthosecanonicalmodelsassumethateconomicagentsmakeintertemporaldecisionsunderrationalexpectations(RE)assumptions.Thismeansthateconomicagentshavefullinformationset,andformexpectationsconsistentlywiththeunderlyingmodelandthepolicyenvironment.SincethebirthofthefirstcanonicalmonetarypolicymodelwithRE,anumberoffrictionshavebeenadded,suchasconsumptionhabitformationandindexationtolaggedinflation,tobetter