The effect of interest rate and exchange rate on inflation targeting with heterogeneous inflation expectations approach

Abstract

The purpose of this study was to investigate the role of policy tools such as interest rate and exchange rate on inflation targeting in the form of new Keynesian model in terms of heterogeneity of economic agents' expectations. For this purpose, the statistical data of the period 1990-2018 were used based on the frequency of seasonal data. In this study, the model of rational expectations and limited expectations based on the pattern of comparative expectations for applying the limitations of the operators of expectation formation in economic agents has been used to predict macroeconomic variables. The results indicate that the shock of the exchange rate and the interest rate through a cost shock led to an increase in the inflation rate. Also, if the expectations of economic agents are rational, they have had less degree of flexibility than expectations have been adapted in a comparative way. Therefore, given the significant impact of the formation of the expectations of economic agents in inflation expectations, it can be seen that inflationary expectations in the country are also exacerbated by inflationary pressures in the country, which will affect the fluctuation of inflation. The transparency and integrity of the information and credibility of policymakers makes economic agents to shape their expectations with the least error and to prevent the negative effects of fluctuations of inflation on expectations change significantly.

Keywords

• heterogeneous expectations
• inflation rate
• exchange rate
• interest rate
• dynamic stochastic general equilibrium model