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Monetary Policy under Behavioral Expectations: Theory and Experiment

Author

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  • Cars Hommes

    (Amsterdam School of Economics (University of Amsterdam) & Tinbergen Institute)

  • Domenico Massaro

    (Universit? Cattolica del Sacro Cuore & Complexity Lab in Economics)

  • Matthias Weber

    (Bank of Lithuania & Faculty of Economics, Vilnius University)

Abstract

Expectations play a crucial role in modern macroeconomic models. We consider a New Keynesian framework under rational expectations and under a behavioral model of expectation formation. We show how the economy behaves in the alternative scenarios with a focus on inflation volatility. Contrary to the rational model, 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 in a learning-to-forecast experiment. The results support the behavioral model and the claim that output stabilization can lead to less volatile inflation.

Suggested Citation

  • Cars Hommes & Domenico Massaro & Matthias Weber, 2017. "Monetary Policy under Behavioral Expectations: Theory and Experiment," Bank of Lithuania Working Paper Series 42, Bank of Lithuania.
    • Handle: RePEc:lie:wpaper:42
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    More about this item

    Keywords

    Experimental macroeconomics; Heterogeneous expectations; LtFE; Tradeoff inflation and output gap;
    All these keywords.

    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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