Animal Spirits and Monetary Policy

Paul De Grauwe

Chapter 18 in Exchange Rates and Global Financial Policies, 2014, pp 473-520 from World Scientific Publishing Co. Pte. Ltd.

Abstract: I develop a behavioral macroeconomic model in which agents have cognitive limitations. As a result, they use simple but biased rules (heuristics) to forecast future output and inflation. Although the rules are biased, agents learn from their mistakes in an adaptive way. This model produces endogenous waves of optimism and pessimism (“animal spirits”) that are generated by the correlation of biased beliefs. I identify the conditions under which animal spirits arise. I contrast the dynamics of this model with a stylized DSGE-version of the model and I study the implications for monetary policies. I find that strict inflation targeting is suboptimal because it gives more scope for waves of optimism and pessimism to emerge thereby destabilizing output and inflation.

Keywords: Exchange Rate; Financial Policies; Turbulence; Exchange Market; Motenary Union; Macroeconomics; Economic Models; Behaviorial Economics; Monetary Integration; Euro; Financial Crisis; European Monetary Policy; Dynamic Stochastic General Equilibriumauthor (search for similar items in EconPapers)
Date: 2014
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Citations: View citations in EconPapers (2)

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Working Paper: Animal Spirits and Monetary Policy (2008)
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