Inflation expectations and macroeconomic dynamics: The case of rational versus extrapolative expectations

The motivation of this paper is to understand the effects of coupling a macroeconomic model of inflation rate dynamics, relying oil an aggregate expectation, to a heterogeneous expectations framework. A standard model composed of Okun's law, an expectations-augmented Phillips curve and an aggregate demand relation is extended to allow agents to select between trend-following and rational expectations to predict the future inflation rate. Using a Mixture of analytical and numerical tools we investigate the model's dynamics and discuss the conditions under which the extended model leads to endogenous fluctuations in macroeconomic variables. Some preliminary results are offered for the case in which a Taylor-like monetary policy rule is included in the model. (C) 2009 Elsevier B.V. All rights reserved.