Bank of Lithuania
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2017-03-30

No 42. Cars Hommes, Domenico Massaro, Matthias Weber. Monetary policy under behavioral expectations: Theory and experiment

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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.

JEL Codes: C90, E03, E52, D84.

The views expressed are those of the author(s) and do not necessarily represent those of the Bank of Lithuania.

Domenico Massaro, Matthias Weber