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Experimental Macroeconomics: Expectations and Monetary Policy Design

Final Report Summary - EXPMAC (Experimental Macroeconomics: Expectations and Monetary Policy Design)

The objective of this Marie Curie Fellowship is to address three issues in the heart of the debate in modern macroeconomics and in particular, in monetary economics. All these issues have been analysed with a new and innovative research methodology within this field: laboratory experiments. This field has a lot of potential to address some of questions regarding monetary policy design as we abstract from the influence of exogenous factors and thus it is quite straightforward to analyse properties of the standard macroeconomic model under different expectation formation processes. The first two issues are concerned with the design of monetary policy: first to establish the relationship between monetary policy and expectation formation mechanism and second to investigate what is the optimal level of transparency and central bank communication strategy to stabilise inflation and output. We search for the design of monetary policy that would perform best in a controlled environment when subject are asked to forecast inflation and output. In order that this can be achieved, inflation expectations should be well anchored. It is expected that several designs proposed in the literature will not prevent the emergence of expectations driven cycles. A third issue that will be addressed in this proposal is to put the standard sticky-price new Keynesian dynamic stochastic general equilibrium (DSGE) model to the test in the laboratory. Using subjects' inputs and decisions in a simplified fictitious economy with households, firms, and policy makers, we will derive the main macroeconomics aggregates and compare their evolution and their reactions to monetary policy changes with the theoretical predictions from the DSGE models and actual observed stylised facts. The final objective of this project is the dissemination of results and organisation of an academic conference on the proposed topic.

In the past year, we addressed the first topic of the Marie Curie grant: we established the relationship between monetary policy and expectation formation mechanism. The results of this part of the research are two working papers: 'Inflation expectations and monetary policy design: Evidence from the laboratory' (with Blaž Žakelj) and 'Uncertainty and disagreement in forecasting inflation: Evidence from the laboratory' (with Blaž Žakelj). The central question in the first paper is how to design monetary policy in an environment characterised by heterogeneous expectations. Rules that use actual rather than forecasted inflation produce lower inflation variability and alleviate expectational cycles. The degree of responsiveness to deviations in inflation from its target in the Taylor rule produces nonlinear effects on inflation variability. We also provide considerable support for the existence of heterogeneity of inflation expectations, while a significant proportion of subjects are rational. However, rather than using a single model most subjects tend to switch between alternative models. The second paper focuses on establishing several stylised facts about the behavior of individual uncertainty, aggregate distribution of forecasts, and disagreement between individuals when forecasting inflation in the laboratory. Subjects correctly perceive the underlying inflation uncertainty in only 60 % of cases and tend to report asymmetric confidence intervals, perceiving higher uncertainty with respect to inflation increases. We find that the average confidence interval is the measure that performs best in forecasting inflation uncertainty. We also compare the behaviour of subjects in different monetary policy environments and find that inflation targeting produces lower uncertainty and higher interval accuracy than inflation forecast targeting.

In the past year, I have also worked on the third topic mentioned above. This has resulted in a working paper 'Frictions, persistence, and central bank policy in an experimental dynamic stochastic general equilibrium economy' (with Charles Noussair and Janos Zsiros). This paper focuses on constructing experimental economies, populated with human subjects, with a structure based on a new Keynesian DSGE model. Experimental methods provide an additional tool to study macroeconomic policy questions. They allow scope for agents' actual boundedly rational behaviour and expectations to influence outcomes, while preserving the incentives and keeping the structure as close as possible to the DSGE model. We consider several specific research questions relating to the persistence of shocks, the behavior of human central bankers, and the pricing behavior of firms. We find that, in a setting where goods are perfect substitutes, there is little persistence of output shocks compared to treatments with monopolistic competition, which perform similarly irrespective of whether or not menu costs are present. Discretionary central banking is associated with greater persistence than automated instrumental rules. Interest rate policies of human discretionary central bankers are characterised by interest rate smoothing, the use of the Taylor principle, and lower output and welfare than under an automated instrumental rule. Patterns in price changes conform closely to stylised empirical facts.

The project so far has already attracted much attention both in academic circles as well as between policy makers. In particular, several central banks have started to investigate the possibility to use the methods and the results of this project to answer issues regarding the design of monetary policy. Also clear understanding of the transmission of monetary policy shocks to both the real and financial sector of the economy and their influence on expectation formation process is necessary for optimal conduct of monetary policy. 'Frictions, persistence, and central bank policy in an experimental dynamic stochastic general equilibrium economy' has addressed these issues. The paper has been well received as it could potentially represent complementary method to other empirical methods used in macroeconomics. Experimental methods allow researchers to create real, though synthetic, economies expressly designed to answer specific research questions. The structure of the economy is allowed to interact with the boundedly rational decisions of human agents to produce macroeconomic activity. However, many of the advantages of calibration exercises are preserved. Parameters such as production and cost functions, the timing and variance of shocks, and the number of producers and consumers, can be manipulated exogenously. Thus, the structure of the economy can conform to the model under investigation, causality can be imposed to distinguish between competing explanations for events or empirical patterns, and variables otherwise unobservable can be observed and precisely measured. Replication of an experiment is possible with multiple groups of randomly assigned subjects. This means that one can create many economies with the same underlying structure. This allows multiple observations to be gathered to enable proper statistical tests, and to allow the potential variability of outcomes to be studied. Furthermore, because subjects from the same population can be assigned to different experimental treatments, and the environment can be controlled, an experiment can be designed so that one or more institutional or environmental elements can be varied, ceteris paribus.