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Trust and monetary policy

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  • De Grauwe, Paul
  • Ji, Yuemei

Abstract

We analyze how trust affects the transmission of negative demand and supply shocks using a behavioral macroeconomic model. We define trust to have two dimensions: trust in the central bank's inflation target and trust in the central bank's capacity to stabilize the business cycle. We find, first, that when large negative shocks occur, the subsequent trajectories taken by output gap and inflation typically coalesce around a good and a bad trajectory. Second, these good and bad trajectories are correlated with movements in trust. In the bad trajectories, trust collapses, and in the good trajectories, it is not affected. This feature is stronger when a negative supply shock occurs than in the case of a negative demand shock. Third, initial conditions, in particular the initial state of inflation and output expectations, matter. Unfavorable initial expectations drive the economy into a bad trajectory, and favorable initial expectations produce good trajectories. Fourth, we analyze the sensitivity of our results with respect to the size of the shocks. Fifth, we derive implications of our results for our capacity of making forecasts about the effects of large demand and supply shocks.

Suggested Citation

  • De Grauwe, Paul & Ji, Yuemei, 2024. "Trust and monetary policy," LSE Research Online Documents on Economics 120871, London School of Economics and Political Science, LSE Library.
  • Handle: RePEc:ehl:lserod:120871
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    File URL: http://eprints.lse.ac.uk/120871/
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    References listed on IDEAS

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    1. Bobeica, Elena & Ciccarelli, Matteo & Vansteenkiste, Isabel, 2021. "The changing link between labor cost and price inflation in the United States," Working Paper Series 2583, European Central Bank.
    2. Yann Algan & Pierre Cahuc, 2010. "Inherited Trust and Growth," American Economic Review, American Economic Association, vol. 100(5), pages 2060-2092, December.
    3. Tiziana Assenza & Te Bao & Cars Hommes & Domenico Massaro, 2014. "Experiments on Expectations in Macroeconomics and Finance," Research in Experimental Economics, in: Experiments in Macroeconomics, volume 17, pages 11-70, Emerald Group Publishing Limited.
    4. De Grauwe, Paul & Ji, Yuemei, 2020. "Structural reforms, animal spirits, and monetary policies," European Economic Review, Elsevier, vol. 124(C).
    5. William A. Brock & Cars H. Hommes, 1997. "A Rational Route to Randomness," Econometrica, Econometric Society, vol. 65(5), pages 1059-1096, September.
    6. Dirk Bursian & Sven Fürth, 2015. "Trust Me! I am a European Central Banker," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 47(8), pages 1503-1530, December.
    7. repec:hal:spmain:info:hdl:2441/432sbils8u9t7qa99cii5psht1 is not listed on IDEAS
    8. William A. Brock & Cars H. Hommes, 2001. "A Rational Route to Randomness," Chapters, in: W. D. Dechert (ed.), Growth Theory, Nonlinear Dynamics and Economic Modelling, chapter 16, pages 402-438, Edward Elgar Publishing.
    9. Pfajfar, Damjan & Žakelj, Blaž, 2014. "Experimental evidence on inflation expectation formation," Journal of Economic Dynamics and Control, Elsevier, vol. 44(C), pages 147-168.
    10. Sjoerd Beugelsdijk & Henri L.F. de Groot & Anton B.T.M. van Schaik, 2004. "Trust and economic growth: a robustness analysis," Oxford Economic Papers, Oxford University Press, vol. 56(1), pages 118-134, January.
    11. Paul De Grauwe, 2012. "Lectures on Behavioral Macroeconomics," Economics Books, Princeton University Press, edition 1, volume 1, number 9891.
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    Cited by:

    1. Paul De Grauwe & Yuemei Ji, 2024. "Monetary Policy and Radical Uncertainty," CESifo Working Paper Series 11068, CESifo.

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    More about this item

    Keywords

    behavioral macroeconomics; monetary policy; trust;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles

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