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INFLATION EXPECTATIONS AND MONETARY POLICY DESIGN: EVIDENCE FROM THE LABORATORY

  • Damjan Pfajfar (a1) and Blaž Žakelj (a2)
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.

Copyright
COPYRIGHT: © Cambridge University Press 2016 
Corresponding author
Address correspondence to: Damjan Pfajfar, Board of Governors of the Federal Reserve System, 20th Street and Constitution Avenue N.W., Washington, DC 20551, USA; e-mail: damjan.pfajfar@frb.gov.
Footnotes
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We would like to thank the associate editor, two anonymous referees, Klaus Adam, Steffan Ball, Bruno Biais, Wändi Bruine de Bruin, Tim Cogley, John Duffy, Chryssi Giannitsarou, Cars Hommes, Seppo Honkapohja, Tobias Klein, Aniol Llorente Saguer, Ramon Marimon, Rosemarie Nagel, Charles Noussair, Jan Potters, Juan Manuel Puerta, John Roberts, Emiliano Santoro, Mike Woodford, and other participants at the Bank of Canada, Bank of England, Humbolt University Berlin, University of Amsterdam, Universitat Pompeu Fabra, Erasmus University Rotterdam, European University Institute, University of Hamburg, Catholic University in Milan, Tilburg University, University of West Virginia, 2nd LICTEM Conference in Barcelona, 2010 New York FRB Conference on Consumer Inflation Expectations, 2008 Learning Week at St. Louis FED, 2008 Computational Economics Conference in Paris, 2008 ESA meetings in Lyon, and 2008 Nordic Conference on Behavioral and Experimental Economics in Copenhagen for their comments and suggestions. The views expressed in this paper are those of the authors and do not necessarily reflect those of the Federal Reserve Board.

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Macroeconomic Dynamics
  • ISSN: 1365-1005
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