Inflation Expectations and Monetary Policy Design: Evidence from the Laboratory (Replaces CentER DP 2009-007)

Using laboratory experiments within a New Keynesian macro framework, we explore the formation of inflation expectations and its interaction with monetary policy design. The central question in this paper is how to design monetary policy in the environment characterized by heterogeneous expectations. Rules that use actual rather than forecasted inflation produce lower inflation variability and alleviate expectational cycles. Degree of responsiveness to deviations of 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 and show that a significant proportion of subjects are rational in our experiment. However, most subjects rather than using a single model they tend to switch between alternative models.