PRECAUTIONARY LEARNING AND INFLATIONARY BIASES

In a canonical monetary policy model in which the central bank learns about underlying fundamentals by estimating the parameters of a Phillips curve, we show that the bank’s loss function is asymmetric such that parameter overestimates may be more or less costly than underestimates, creating a precautionary motive in estimation. This motive suggests the use of a more efficient variance-adjusted least-squares estimator for learning about fundamentals. Informed by this “precautionary learning” the central bank sets low inflation targets, and the economy can settle near a Ramsey equilibrium.