Deviations from the Taylor Rule as an Expectations Signal: Learning under Dual-Rate Divergence in Small Open Economies

Shevchuk (2023) finds that in CEE countries the policy rate often undershoots the Taylor-implied rate, with heterogeneous macro effects and a contractionary-inflationary exchange rate channel. Alpanda, Honig, and Woglom (2011) already highlight the importance of a risk-premium wedge between the policy rate and the demand-relevant rate, and allow for deviations from a Taylor rule. This project unifies these insights in a learning model where firms and households observe both: (i) the policy rate vs. a transparent Taylor benchmark, and (ii) the market effective rate shaped by a time-varying premium. Agents form beliefs about the central bank’s reaction function and inflation target as a function of these deviations—a “dual-rate divergence” signal—interacting with exchange rate pass-through in small open economies. We examine whether persistent undershooting weakens expectations anchoring, amplifies exchange rate-driven inflation, and shifts the economy into a positive feedback regime more prone to bubbles or currency overshooting (cf. Bao et al.’s evidence on positive feedback markets). Methodologically, we estimate a TVP-SVAR or state-space model with survey expectations and high-frequency financial indicators (yield curve, FX futures), then embed the estimated belief rules into a small open-economy DSGE that replaces RE with least-squares/level-k learning (Milani 2012; Bersson et al. 2023). This differs from standard Taylor-rule estimations by treating rule deviations as information content for expectations, not mere residuals. The implications are immediate for policy design in emerging markets: transparency about risk-premium wedges and explicit communication around rule deviations could materially re-anchor beliefs and temper exchange rate pass-through.

References:

1. Extending the Textbook Dynamic AD-AS Framework with Flexible Inflation Expectations, Optimal Policy Response to Demand Changes, and the Zero-Bound on the Nominal Interest Rate. Sami Alpanda, Adam Honig, G. Woglom (2011).
2. Expectation Formation in Finance and Macroeconomics: A Review of New Experimental Evidence. T. Bao, C. Hommes, Jiaoying Pei (2021). Social Science Research Network.
3. The Macroeconomic Effects of the Taylor Rule Deviations in Central and Eastern European Countries. Viktor Shevchuk (2023). Prace Naukowe Uniwersytetu Ekonomicznego we Wrocławiu.
4. Expectations Formation, Sticky Prices, and the ZLB. Elizabeth Bersson, P. Hürtgen, Matthias O. Paustian (2023). Social Science Research Network.
5. Expectation Formation and Monetary DSGE Models: Beyond the Rational Expectations Paradigm. Fabio Milani, A. Rajbhandari (2012).