Regime changes, learning and monetary policy

Monetary policymakers should be concerned with potential changes in regime. In the model presented here, increasing returns in production creates the possibility of multiple expectationally stable steady states. The policymaker tries to achieve the two goals of smoothing fluctuations around the high output steady state, while trying to prevent the economy from slipping to the inferior, low output steady state. Agents use a learning rule to make forecasts and a key parameter in the rule provides an indication of the credibility of the policymaker. The greater the magnitude of the shocks and the lower the credibility of the policymaker, the more emphasis should be placed on stabilizing output. (c) 2007 Elsevier Inc. All rights reserved.