Price stability and volatility in markets with positive and negative expectations feedback: an experimental investigation

The evolution of many economic variables is affected by expectations that economic agents have with respect to the future development of these variables. Here we show, by means of laboratory experiments, that market behavior depends to a large extent on how the realized market price responds to an increase in average price expectations. If it responds by decreasing, as in commodity markets, prices converge quickly to their equilibrium value, confirming the rational expectations hypothesis. If the realized price increases after an increase of average expectations, as is typical for financial markets, large fluctuations in realized prices are likely

How do inflation expectations form? New insights from a high-frequency survey

We provide new insights on the formation of inflation expectations - in particular at a time of great financial and economic turmoil - by evaluating results from a survey conducted from July 2009 through July 2010. Participants in this survey answered a weekly questionnaire about their short-, medium- and long-term inflation expectations. Participants received common information sets with data relevant to euro area inflation. Our analysis of survey responses reveals several interesting results. First, our evidence is consistent with long-term expectations having remained well anchored to the ECB's definition of price stability, which acted as a focal point for long-term expectations. Second, the turmoil in euro area bond markets triggered by the Greek fiscal crisis influenced short- and mediumterm inflation expectations but had only a very small impact on long-term expectations. By contrast, long-term expectations did not react to developments of the euro area wide fiscal burden. Third, participants changed their expectations fairly frequently. The longer the horizon, the less frequent but larger these changes were. Fourth, expectations exhibit a large degree of time-variant non-normality. Fifth, inflation expectations appear fairly homogenous across groups of agents at the shorter horizon but less so at the medium- and long-term horizons.Inflation expectations; monetary policy; crisis

How do inflation expectations form? New insights from a high-frequency survey

We provide new insights on the formation of inflation expectations - in particular at a time of great financial and economic turmoil - by evaluating results from a survey conducted from July 2009 through July 2010. Participants in this survey answered a weekly questionnaire about their short-, medium- and long-term inflation expectations. Participants received common information sets with data relevant to euro area inflation. Our analysis of survey responses reveals several interesting results. First, our evidence is consistent with long-term expectations having remained well anchored to the ECB's definition of price stability, which acted as a focal point for long-term expectations. Second, the turmoil in euro area bond markets triggered by the Greek fiscal crisis influenced short- and medium-term inflation expectations but had only a very small impact on long-term expectations. By contrast, longterm expectations did not react to developments of the euro area wide fiscal burden. Third, participants changed their expectations fairly frequently. The longer the horizon, the less frequent but larger these changes were. Fourth, expectations exhibit a large degree of timevariant non-normality. Fifth, inflation expectations appear fairly homogenous across groups of agents at the shorter horizon but less so at the medium- and long-term horizons.inflation expectations, monetary policy, crisis

Price stability and volatility in markets with positive and negative expectations feedback: An experimental investigation

The evolution of many economic variables is affected by expectations that economic agents have with respect to the future development of these variables. We show, by means of laboratory experiments, that market behavior depends to a large extent on whether realized market prices respond positively or negatively to average price expectations. In the case of negative expectations feedback, as in commodity markets, prices converge quickly to their equilibrium value, confirming the rational expectations hypothesis. In the case of positive expectations feedback, as is typical for speculative asset markets, large fluctuations in realized prices and persistent deviations from the benchmark fundamental price are likely. We estimate individual forecasting rules and investigate how these explain the differences in aggregate market outcomes.Market behavior Coordination Expectations feedback Experimental economics

Individual Expectations and Aggregate Macro Behavior

The way in which individual expectations shape aggregate macroeconomic variables is crucial for the transmission and effectiveness of monetary policy. We study the individual expectations formation process and the interaction with monetary policy, within a standard New Keynesian model, by means of laboratory experiments with human subjects. We find that a more aggressive monetary policy that sets the interest rate more than point for point in response to inflation stabilizes inflation in our experimental economies. We use a simple model of individual learning, with a performance-based evolutionary selection among heterogeneous forecasting heuristics, to explain coordination of individual expectations and aggregate macro behavior observed in the laboratory experiments. Three aggregate outcomes are observed: convergence to some equilibrium level, persistent oscillatory behaviour and oscillatory convergence. A simple heterogeneous expectations switching model fits individual learning as well as aggregate outcomes and outperforms homogeneous expectations benchmarks.Experiments; Monetary Policy; Expectations; Heterogeneity

Inflation Expectations and Stability in an Overlapping Generations Experiment with Money Creation

We investigate how non-specialists form inflation expectations by running an experiment using a basic Overlapping Generations (OLG) model. The participants of the experiment are students of the University of Amsterdam, who predict inflation during 50 successive periods and are rewarded based on their accuracy. We include a central bank in the OLG model which increases the money supply at a constant rate. Participants are placed in separate OLG economies and are divided over two treatments: one with a "low" and one with a "high" money supply growth. We find that participants in the second treatment have substantially more difficulty in stabilizing inflation development by submitting accurate predictions than participants in the first treatment. However, when linear prediction rules are estimated on individual predictions, there is little difference between the two treatments. In both treatments, the most popular rules are Fundamentalist Expectations (predictions equal to the inflation sample mean) and Focal Expectations (predictions equal to a constant close to equilibrium). To verify whether participants adjust their prediction rules during the experiment, the estimated rules are checked for structural breaks. We find a surprisingly small number of structural breaks in both treatments.Experimental economics; Expectations feedback; Inflation expectations; Price stability; Anchoring.