The (mis)perceived Slope of the Phillips Curve: Monetary Policy with Limited Aware Agents

01 Mar 2023 - 12:00 / 13:00

207, Viale Romania

Speaker: Luigi Iovino , Bocconi University

Authors: Davide Debortoli, Luigi Iovino, Nicola Pavoni, Donghai Zhang


Do agents understand well the determinants of the trade-off between output and inflation? What are the sources of their possible "mistakes"? We combine data on aggregate variables and individual expectations from the Survey of Professional Forecasters to derive a new test for Rational Expectations (RE). The test is based on cross-variable restrictions between forecast errors about inflation and past expected output. The test rejects the RE hypothesis. We provide an interpretation of the empirical evidence based on agents that are unaware of supply shocks and, hence, commit an omitted variable bias when inferring the trade-off between output and inflation. We cast limited awareness into an otherwise standard New-Keynesian model and show that the presence of limited-aware agents increases the output cost of reducing inflation. In addition, when observing changes in the nominal interest rate that contains information about the state of the economy, limited-aware agents interpret signals in a biased way, possibly leading to over-reaction or under-reaction to news. The model can help address some "puzzles" of the New-Keynesian setup.