On the role of heuristics—Experimental evidence on inflation dynamics

Abstract

We run an experiment where groups of six subjects must set prices in a non-stationary macroeconomic environment, where prices are complements. The exogenous variable, a business indicator, is common knowledge and prices are flexible, disregarding sticky prices or sticky information. In a first treatment subjects insignificantly corrected for past errors, which implies that history plays a role for determining current prices. By reporting the business indicator in a simpler form the second treatment tacitly offered a heuristic for setting prices. This option was widely taken, bringing about an excess response to the business indicator and a significant deviation from equilibrium even in the long run. In a third treatment with staggered pricing we observe that subjects look only one round into the future but not further ahead, contrary to theoretical predictions. Our findings suggest that monetary transmission may be impaired due to what we label sticky reasoning, the failure or unwillingness to iteratively delete dominated strategies.