Template-Type: ReDIF-Paper 1.0
Series: Tinbergen Institute Discussion Papers
Creation-Date: 2015-07-27
Number: 15-087/II
Author-Name: Cars Hommes
Author-Workplace-Name: University of Amsterdam
Author-Name: Domenico Massaro
Author-Workplace-Name: University of Amsterdam
Author-Name: Matthias Weber
Author-Workplace-Name: University of Amsterdam
Title: Monetary Policy under Behavioral Expectations: Theory and Experiment
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.
Classification-JEL: C90, E03, E52, D84
Keywords: Experimental Macroeconomics, Heterogeneous Expectations, Learning to forecast Experiment, Trade-off Inflation and Output Gap
File-Url: https://papers.tinbergen.nl/15087.pdf
File-Format: application/pdf
File-Size: 534498 bytes
Handle: RePEc:tin:wpaper:20150087