Anchoring of Expectations: The Role of Credible Targets in a Game Experiment

Bodo Herzog

doi:10.18533/jefs.v3i6.169

Abstract

This paper provides new evidence on the formation and anchoring of inflation expectations. I conduct a game experiment and analyze the adjustment as well as the impact of credible targets on expectations. In addition, I evaluate the idiosyncratic determinants on the formation of expectations. The analysis reveals six results: First, I find evidence that long-term inflation expectations are firmly anchored to a credible target. Second, a temporary deviation due to unexpected monetary policy might trigger a decline in credibility, and third a de-anchoring of expectations due to uncertainty. Fourth, I find that people change their expectations little if a credible target exists. Fifth, expectations exhibit a large degree of time-variance only in environments without a target. Sixth, the dynamic adjustment to an ‘incomplete’ equilibrium, which is theoretically unstable, is nevertheless rapid and persistent in case of credible targets. All in all, I demonstrate a unique game setup with contributions to both experimental and monetary economics.

Highlights

Central bankers and academics emphasize the importance of low and stable inflation rates
It is needless to say that the European Central Bank's (ECB) primary objective is to maintain price stability according to the article 127(1) Treaty of the Functioning of the European Union (TFEU)
The TFEU does not provide an explicit definition of price stability, the ECB operationalizes this statement by “A Harmonized Index of Consumer Prices for the euro area below, but close to 2% over the medium term.”

Summary

Introduction

Central bankers and academics emphasize the importance of low and stable inflation rates. Central banks have to anchor the expected inflation rate at the official inflation target This requires independence and, even more importantly, credibility of monetary policy. The erosion of credibility may continue, and gets even more severe, provided that uncertainty increases due to interest rates at the zero lower bound, for instance Given this ambiguous environment, I find in the experiment that increasing uncertainty (created via hidden cheating in the game) impairs credibility and de-anchors the inflation expectations. I find in the experiment that increasing uncertainty (created via hidden cheating in the game) impairs credibility and de-anchors the inflation expectations Fourth, people change their views and expectations only a little if the target is credible.

Literature review

Results and discussion

4.01 Results of the game experiment

Conclusion