This paper reevaluates the basic prescriptions of monetary policy design in the new Keynesian paradigm through the lens of imperfect knowledge. We show that while the basic logic of monetary policy design under rational expectations continues to obtain, perfect knowledge and learning can limit the set of policies available to central banks, rendering expectations management in general more difficult. Nonetheless, the desirability of some form of price-level targeting, inducing inertia in interest-rate policy, paramount under rational expectations, is robust to the assumption of imperfect knowledge.

This paper proposes a theory of the fiscal foundations of inflation based on imperfect knowledge and learning. Because imperfect knowledge breaks Ricardian equivalence, the scale and composition of the public debt matter for inflation. High and moderate duration debt generates wealth effects on consumption demand that impairs the intertemporal substitution channel of monetary policy: aggressive monetary policy is required to anchor inflation expectations. Counterfactual experiments conducted in an estimated model reveal that the US economy would have been substantially more volatile over the Great Inflation and Great Moderation periods if US debt levels had been those observed in Italy or Japan.

This paper develops a theory of expectations-driven business cycles based on learning. Agents have incomplete knowledge about how market prices are determined and shifts in expectations of future prices affect dynamics. Learning breaks the tight link between fundamentals and equilibrium prices, inducing periods of erroneous optimism or pessimism about future returns to capital and wages which subsequent data partially validate. In a real business cycle model, the theoretical framework amplifies and propagates technology shocks. Moreover, it produces agents' forecast errors consistent with business cycle properties of forecast errors for a wide range of variables from the Survey of Professional Forecasters. JEL: C53, D83, D84, E32, E37

This paper provides theory and evidence that distorted long-term interest rate expectations limit the effectiveness of monetary policy. Beliefs that depart from rational expectations break the tight link between policy rates and long-term interest rates, even when determined by the expectations hypothesis of the yield curve. Because long-term expectations are excessively sensitive to short-term interest rates, optimal policy is less aggressive relative to rational expectations. More aggressive policy leads to suboptimal volatility in long-term interest rates and aggregate demand through standard intertemporal substitution effects. These effects are quantitatively important in the United States over the postwar period.