History-dependent monetary policy: a lab experiment and a HENK model

Abstract

Price-level targeting (PLT) is theoretically optimal under the full information rational expectations (FIRE) benchmark but has not been implemented in practice. We use a laboratory experiment to collect data on expectations, inflation and output dynamics under a traditional inflation targeting (IT) framework and a PLT regime with both deflationary and cost-push shocks. A heterogeneous expectation New Keynesian (HENK) model with forward-looking communication can replicate the dynamics observed in the lab. We do not observe the benefits of PLT over IT because both human subjects and HENK agents are unable to learn the history-dependent inflation path, which results in excess macroeconomic volatility. However, once augmented with an inflation guidance consistent with closing the price gap, the advantage of PLT materializes, both in the lab and in the model, and the inflation gap is minimized no matter the type of shocks. The model offers a behavioral narrative for the cross-regime differences observed in the experiment. Combining laboratory data with the HENK framework is a promising addition to the central banks’ toolkit since it offers a first test of their policies.