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Coordinating expectations through central bank projections

Fatemeh Mokhtarzadeh () and Luba Petersen ()
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Fatemeh Mokhtarzadeh: University of Victoria
Luba Petersen: Simon Fraser University

Experimental Economics, 2021, vol. 24, issue 3, No 7, 883-918

Abstract: Abstract Central banks are increasingly communicating their economic outlook in an effort to manage the public and financial market participants’ expectations. We provide original causal evidence that the information communicated and the assumptions underlying a central bank’s projection can matter for expectation formation and aggregate stability. Using a between-subject design, we systematically vary the central bank’s projected forecasts in an experimental macroeconomy where subjects are incentivized to forecast the output gap and inflation. Without projections, subjects exhibit a wide range of heuristics, with the modal heuristic involving a significant backward-looking component. Ex-Ante Rational dual projections of the output gap and inflation significantly reduce the number of subjects’ using backward-looking heuristics and nudge expectations in the direction of the rational expectations equilibrium. Ex-Ante Rational interest rate projections are cognitively challenging to employ and have limited effects on the distribution of heuristics. Adaptive dual projections generate unintended inflation volatility by inducing boundedly-rational forecasters to employ the projection and model-consistent forecasters to utilize the projection as a proxy for aggregate expectations. All projections reduce output gap disagreement but increase inflation disagreement. Central bank credibility is significantly diminished when the central bank makes larger forecast errors when communicating a relatively more complex projection. Our findings suggest that inflation-targeting central banks should strategically ignore agents’ irrationalities when constructing their projections and communicate easy-to-process information.

Keywords: Expectations; Monetary policy; Projections; Communication; Credibility; Laboratory experiment; Experimental macroeconomics (search for similar items in EconPapers)
JEL-codes: C9 D84 E52 E58 (search for similar items in EconPapers)
Date: 2021
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DOI: 10.1007/s10683-020-09684-6

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