This paper investigates monetary policy design when central bank and private-sector
expectations differ. Private agents learn adaptively; the central bank has a possibly
misspecified model of the economy. Successful implementation of optimal policy using
inflation targeting rules requires the central bank to have complete knowledge of private
agents' learning behavior. If the central bank mistakenly assumes private agents to have
rational expectations when in fact they are learning, then policy rules frequently lead to …

How should private-sector forecasts be incorporated into the design of optimal monetary
policy? This paper addresses this question using the framework of Preston (2002) in which
private agents, rather than forming expectations rationally, use an econometric model to
learn the true model of the economy over time. The analysis shows that the central bank
requires complete knowledge of private agents' behavior and its implications for aggregate
dynamics to guarantee successful implementation of optimal monetary policy using specific …