Heterogeneous Expectations and the Business Cycle

We analyze the empirical relevance of heterogeneous expectations and central bank credibility in a canonical New Keynesian model subject to the effective lower bound (ELB). Agents switch between an anchored rational expectations (RE) and an adaptive learning forecast rule, where the latter may result in a de-anchoring of inflation expectations. We estimate the model for the U.S. economy using aggregate macro data and survey data on inflation expectations. We use the estimated model to examine the interaction between the risk of deflationary spirals and central bank credibility at the ELB. A loss of central bank credibility increases the probability of deflationary spirals, highlighting the importance of keeping inflation expectations anchored during periods of uncertainty.

Authors

• Tolga Özden

JEL codes

• E37
• E65
• C11
• C32