Tuesday, November 5, 2013

The experimental macroeconomics of monetary policy

One important characteristic of Economics is that it is very difficult to conduct a clean experiment. While one may run little laboratory experiments with a few chosen subjects, there is always the uncertainty whether the experiment generalizes. The randomized experiments typically used in development economics are subject to the same limitations, even if their scope is larger. And in all those experiments, their applicability is limited to microeconomic questions.

Oleksiy Kryvtsov and Luba Petersen venture into experiments directly applicable for macroeconomic policy, and more precisely monetary policy. Monetary policy has bite when there are some frictions, among them expectation formation. Their idea is thus to see how people form inflation expectations in a laboratory setting and within the context of a standard new-Keynesian model. In that model with economic agents having rational expectations, monetary policy can reduce macroeconomic volatility by at least two-thirds. With the bit of irrationality exhibited by participants to the experiment, the reduction is still about half, and thus important. The model is a Woodford-style economy where participants have to provide updates on inflation and output-gap expectations, which can be compared by the observer against rational expectations ones. People learn about changes to fundamentals and can draw on past history. In other words, it is like they would live in the Matrix, they are fed information and are supposed to behave within the confines of a virtual world.

This is very interesting and innovative stuff here. I must concede though that I have still not bought the Woodford model. I cannot understand how one can talk about monetary policy in model with supposedly fundamentals when there is no money.

1 comment:

Anonymous said...

There's a related paper, that uses experimental evidence to explain macroeconomic phenomena.