Expectations and Monetary Policy: Experimental Evidence

The effectiveness of monetary policy depends, to a large extent, on market expectations of its future actions. In a standard New Keynesian business cycle model with rational expectations, systematic monetary policy reduces the variance of inflation and output gap by at least two-thirds. These stabilization benefits can be substantially smaller if expectations are non-rational. We design an economic experiment that identifies the contribution of expectations to macroeconomic stabilization achieved by systematic monetary policy. We find that, despite some non-rational component in expectations formed by experiment participants, monetary policy is quite potent in providing stabilization, reducing roughly a half of macroeconomic variance.te potent in providing stabilization, reducing roughly a half of macroeconomic variance.