Experimental Evidence on the Persistence of Output and Inflation

This paper presents experimental evidence from a monetary sticky price economy in which output and inflation depend on expectations of future inflation. In the unique stationary rational expectations equilibrium (REE) nominal demand shocks cause output and inflation to be white noise. In the experimental sessions, however, output and inflation display strong persistence and regular cyclical patterns. Such behavior emerges because subjects’ inflation expectations in the experiments fail to be captured by rational expectations functions. Instead, the expectations functions of a Restricted Perceptions Equilibrium (RPE), which assumes that agents use optimal but ’simple’ forecast functions, captures subjects’ expectations surprisingly well. Over time expectations seem to start deviating from RPE expectations but evidence in favor of convergence towards the REE remains weak, even after more than 100 model periods. For model parameterizations where the RPE fails to exist, subjects’ inflation expectations are captured much better by rational expectations functions.