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Monetary Policy Under Behavioral Expectations: Theory and Experiment

Tinbergen Institute Discussion Paper 15-087/II

Bank of Lithuania Working Paper 42/2017

69 Pages Posted: 28 Jul 2015 Last revised: 6 Apr 2017

Cars H. Hommes

University of Amsterdam - Amsterdam School of Economics (ASE); CeNDEF; Tinbergen Institute

Domenico Massaro

Catholic University of Milan; University of Amsterdam - CeNDEF

Matthias Weber

Bank of Lithuania - Center for Excellence in Finance and Economic Research (CEFER); Vilnius University

Date Written: July 18, 2015

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.

Keywords: Behavioral Macroeconomics, Experimental Macroeconomics, Heterogeneous Expectations, LtFE, Trade-off Inflation and Output Gap

JEL Classification: C90, E03, E52, D84

Suggested Citation

Hommes, Cars H. and Massaro, Domenico and Weber, Matthias, Monetary Policy Under Behavioral Expectations: Theory and Experiment (July 18, 2015). Bank of Lithuania Working Paper 42/2017. Available at SSRN: https://ssrn.com/abstract=2636234 or http://dx.doi.org/10.2139/ssrn.2636234

Cars H. Hommes (Contact Author)

University of Amsterdam - Amsterdam School of Economics (ASE) ( email )

Center for Nonlinear Dynamics in Economics and Finance
1018 WB Amsterdam
Netherlands
+31 20 525 4246 (Phone)
+31 20 525 4349 (Fax)

CeNDEF ( email )

Roetersstraat 11
Amsterdam, NL-1018WB
Netherlands

HOME PAGE: http://www1.fee.uva.nl/cendef/

Tinbergen Institute ( email )

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

Domenico Massaro

Catholic University of Milan ( email )

Largo Gemelli, 1
Via Necchi 9
Milan, MI 20123
Italy

University of Amsterdam - CeNDEF ( email )

Roetersstraat 11
Amsterdam, 1018 WB
Netherlands

Matthias Weber

Bank of Lithuania - Center for Excellence in Finance and Economic Research (CEFER) ( email )

Totoriu g. 4
Vilnius, LT-01121
Lithuania

Vilnius University ( email )

Sauletekio ave. 11, Vilnius
Vilnius
Lithuania

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