Inflation Expectations and Monetary Policy Design: Evidence from the Laboratory

FEDS Working Paper No. 2015-045

http://dx.doi.org/10.17016/FEDS.2015.045

40 Pages Posted: 10 Jul 2015

See all articles by Damjan Pfajfar

Damjan Pfajfar

Board of Governors of the Federal Reserve System

Blaz Zakelj

Universitat Pompeu Fabra

Date Written: June 11, 2015

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.

Keywords: Inflation Expectations, Laboratory Experiments, Monetary Policy Design, New Keynesian Model

JEL Classification: E37, E52, C92, C91

Suggested Citation

Pfajfar, Damjan and Zakelj, Blaz, Inflation Expectations and Monetary Policy Design: Evidence from the Laboratory (June 11, 2015). FEDS Working Paper No. 2015-045. Available at SSRN: https://ssrn.com/abstract=2628244 or http://dx.doi.org/10.2139/ssrn.2628244

Damjan Pfajfar (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Blaz Zakelj

Universitat Pompeu Fabra ( email )

Ramon Trias Fargas, 25-27
Barcelona, E-08005
Spain
+34 93 542 1998 (Phone)
+34 93 542 2533 (Fax)

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