The paper studies the transmission of monetary policy through its effects on the exchange rate and on long-term interest rates under different schemes of expectations formation, within the framework of the quarterly model of the Banca d'Italia (BIQM). Equations for exchange rate and inflation expectations and for long-term yields are estimated, based on Forum-ME survey data. We find that exchange rate expectations exhibit adaptive behavior, that official rate changes have a sizeable effect on inflation expectations and that long-term rates respond to changes in inflation expectations.
The second part of the paper analyzes the effects of monetary policy in the BIQM with both the estimated equations and the assumption of rational expectations. In both cases the effectiveness of monetary policy is mainly due to its effects on the exchange rate.
Under the estimated mechanism of expectations formation, the speed of adjustment to lower inflation is slower and the output costs are more persistent than under fully rational expectations; the initial effect on output of a monetary tightening, however, is larger under rational expectations, due to overshooting of the exchange rate.
