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Monetary Policy under Behavioral Expectations: Theory and Experiment

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  • Cars Hommes

    (University of Amsterdam)

  • Domenico Massaro

    (University of Amsterdam)

  • Matthias Weber

    (University of Amsterdam)

Abstract

Expectations play a crucial role in modern macroeconomic models. We replace the common assumption of rational expectations in a New Keynesian framework by the assumption that expectations are formed according to a heuristics switching model that has performed well in earlier work. We show how the economy behaves under these assumptions with a special focus on inflation volatility. Contrary to comparable models based on full rationality, the behavioral model predicts that inflation volatility can be lowered if the central bank reacts to the output gap in addition to inflation. We test the opposing theoretical predictions with a learning to forecast experiment. The experimental results support the behavioral model and the claim that reacting to the output gap in addition to inflation can indeed lower inflation volatility.

Suggested Citation

  • Cars Hommes & Domenico Massaro & Matthias Weber, 2015. "Monetary Policy under Behavioral Expectations: Theory and Experiment," Tinbergen Institute Discussion Papers 15-087/II, Tinbergen Institute.
  • Handle: RePEc:tin:wpaper:20150087
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    1. repec:eee:eecrev:v:100:y:2017:i:c:p:72-94 is not listed on IDEAS
    2. Camille Cornand & Frank Heinemann, 2018. "Experiments on macroeconomics: methods and applications," Post-Print halshs-01809937, HAL.
    3. Camille Cornand & Frank Heinemann, 2018. "Experiments on macroeconomics: methods and applications," Working Papers 1810, Groupe d'Analyse et de Théorie Economique Lyon St-Étienne (GATE Lyon St-Étienne), Université de Lyon.

    More about this item

    Keywords

    Experimental Macroeconomics; Heterogeneous Expectations; Learning to forecast Experiment; Trade-off Inflation and Output Gap;

    JEL classification:

    • C90 - Mathematical and Quantitative Methods - - Design of Experiments - - - General
    • E03 - Macroeconomics and Monetary Economics - - General - - - Behavioral Macroeconomics
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations

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