Analyzing Inflation Expectations and the Impact of Target Credibility in Monetary Policy

This paper provides new evidence on the formation and anchoring process of expectations. We conduct a game experiment and measure the convergence of inflation expectations as well as the impact of credible targets in central banking. In addition, we evaluate the idiosyncratic variables of our participants on the inflation formation process. The analysis reveals five results: First, we find evidence that long-term inflation expectations are firmly anchored to a credible target. Second, the monetary policy response on the financial and sovereign debt crisis might trigger a decline in credibility, and therefore de-anchor expectations due to higher uncertainty. Third, participants change their expectations rather little if a credible target exists. Fourth, expectations exhibit a large degree of time-variance only in environments without a target. Fifth, the dynamic adjustment to a quasi-equilibrium, which is theoretical unstable, turns out to be incredibly fast and stable in case of a credible target. All in all, this paper applies a unique game experiment which contributes in several ways to an even established literature on monetary economics