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Inflation Expectations and Monetary Policy Design: Evidence from the Laboratory

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  • Pfajfar, Damjan

    () (Board of Governors of the Federal Reserve System (U.S.))

  • Žakelj, Blaž

    (Universitat Pompeu Fabra)

Abstract

Using laboratory experiments within a New Keynesian framework, we explore the interaction between the formation of inflation expectations and monetary policy design. The central question in this paper is how to design monetary policy when expectations formation is not perfectly rational. Instrumental rules that use actual rather than forecasted inflation produce lower inflation variability and reduce expectational cycles. A forward-looking Taylor rule where a reaction coefficient equals 4 produces lower inflation variability than rules with reaction coefficients of 1.5 and 1.35. Inflation variability produced with the latter two rules is not significantly different. Moreover, the forecasting rules chosen by subjects appear to vary systematically with the policy regime, with destabilizing mechanisms chosen more often when inflation control is weaker.

Suggested Citation

  • Pfajfar, Damjan & Žakelj, Blaž, 2015. "Inflation Expectations and Monetary Policy Design: Evidence from the Laboratory," Finance and Economics Discussion Series 2015-45, Board of Governors of the Federal Reserve System (US).
  • Handle: RePEc:fip:fedgfe:2015-45
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    File URL: http://dx.doi.org/10.17016/FEDS.2015.045
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Volha Audzei & Sergey Slobodyan, 2018. "Sparse Restricted Perception Equilibrium," Working Papers 2018/8, Czech National Bank.
    2. Camille Cornand & Frank Heinemann, 2018. "Experiments on macroeconomics: methods and applications," Working Papers halshs-01809937, HAL.
    3. Camille Cornand & Frank Heinemann, 2018. "Experiments on macroeconomics: methods and applications," Post-Print halshs-01809937, HAL.
    4. Camille Cornand & Paul Hubert, 2018. "On the external validity of experimental inflation forecasts: A comparison with five categories of field expectations," Working Papers halshs-01890770, HAL.
    5. Cars Hommes & Domenico Massaro & Isabelle Salle, 2019. "Monetary And Fiscal Policy Design At The Zero Lower Bound: Evidence From The Lab," Economic Inquiry, Western Economic Association International, vol. 57(2), pages 1120-1140, April.
    6. Choi, Yoonseok & Kim, Sunghyun, 2016. "Testing an alternative price-setting behavior in the new Keynesian Phillips curve: Extrapolative price-setting mechanism," International Review of Economics & Finance, Elsevier, vol. 44(C), pages 253-265.

    More about this item

    Keywords

    Inflation expectations; laboratory experiments; monetary policy design; New Keynesian model;

    JEL classification:

    • C91 - Mathematical and Quantitative Methods - - Design of Experiments - - - Laboratory, Individual Behavior
    • C92 - Mathematical and Quantitative Methods - - Design of Experiments - - - Laboratory, Group Behavior
    • E37 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Forecasting and Simulation: Models and Applications
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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