Experience-Based Heterogeneity in Expectations and Monetary Policy

We show within a New Keynesian model with overlapping generations that experience-based heterogeneity in expectations across age groups affects monetary policy’s effectiveness in stabilising inflation and in closing the output gap. In our model agents only use lifetime observations to forecast macroeconomic variables like inflation or output. A variation in the age distribution has a composition effect on aggregate expectations, which are a size-weighted average over cohort-specific expectations. We show that an increase in the share of old individuals implies an increase in the transmission of monetary policy on inflation but aggravates its stabilisation tradeoff under supply shocks via the composition effect. Thus, the age distribution has a novel impact on monetary policy that is absent from standard models.