DP4885 Experimental Evidence on the Persistence of Output and Inflation

Author(s): Klaus Adam

Publication Date: January 2005

Keyword(s): experiments , output and inflation dynamics , restricted perceptions equilibrium , rational expectations

JEL(s): C91 , E32 , E37

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP4885.asp

This paper presents experimental evidence from a monetary sticky price economy in which output and inflation depend on expected future inflation. With rational inflation expectations, the economy does not generate persistent deviations of output and inflation in response to a monetary shock. In the experimental sessions, however, output and inflation display considerable persistence and regular cyclical patterns. Such behaviour emerges because subjects’ inflation expectations fail to be captured by rational expectations functions. Instead, a Restricted Perceptions Equilibrium (RPE), which assumes that agents use optimal but ’simple’ forecast functions, describes subjects’ inflation expectations surprisingly well and explains the observed behaviour of output and inflation.