RWP 25-04, June 2025
Households’ inflation expectations are often inconsistent with the full information rational expectation. Economic theory predicts that these belief distortions affect the business cycle. How then might monetary policy respond? We investigate with a model-free approach using high-frequency monetary policy shocks and a structural VAR method to identify the effects of shocks to belief distortions. Belief distortion shocks are contractionary; if households become overly pessimistic about inflation, then unemployment and deflation follow. Intuitively, our method implies that the optimal policy response is to ease: a 1 percentage point increase in the belief distortion is optimally offset by a 0.85 percentage point surprise interest rate decrease. Unconventional monetary policy is less effective than using short-run rates in our setting.
JEL Classifications: E52, E30, D84, E70
Article Citation
Adams, Jonathan J. and Symeon Taipliadis. 2025. “The Optimal Policy Response to Belief Distortions: Model-Free Evidence.” Federal Reserve Bank of Kansas City, Research Working Paper no. 25-04, June. Available at External Linkhttps://doi.org/10.18651/RWP2025-04.