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Doves, Hawks and Pigeons: Behavioral Monetary Policy and Interest Rate Inertia

Federico Favaretto and Donato Masciandaro ()

No 1621, BAFFI CAREFIN Working Papers from BAFFI CAREFIN, Centre for Applied Research on International Markets Banking Finance and Regulation, Universita' Bocconi, Milano, Italy

Abstract: Behavioral bias – loss aversion – can explain monetary policy inertia in setting interest rates. Economic literature has tended to explain inertia in monetary policymaking in terms of frictions and delays, or has stressed the role of governance rules. We introduce a new driver of inertia, independent from frictions and central bank governance settings: a Monetary Policy Committee (MPC) that takes decisions on interest rates by voting according to a majority rule, in an economy with nominal price rigidities and rational expectations. Central bankers are senior officials, high-ranking bureaucrats who care about their careers and can be divided into three groups, depending on their level of inflation conservatism: doves, pigeons, and hawks. While a conservative stance doesn’t necessarily produce monetary inertia, we show that introducing loss aversion in individual behavior influences the stance of monetary policy under three different but convergent perspectives. First of all, a Moderation Effect can emerge, i.e. the number of pigeons increases. At the same time also a Hysteresis Effect can become relevant, whereby both doves and hawks soften their attitudes. Finally a Smoothing Effect tends to stabilize the number of pigeons. Together, the three effects consistently cause higher monetary policy inertia.

Keywords: Monetary Policy; Behavioral Economics (search for similar items in EconPapers)
JEL-codes: E5 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-mac, nep-mon and nep-upt
Date: 2016
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