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Animal spirits and monetary policy

de Grauwe, Paul (2011) Animal spirits and monetary policy. Economic Theory, 47 (2-3). pp. 423-457. ISSN 0938-2259

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Abstract

I develop a behavioral macroeconomic model in which agents have cognitive limitations. As a result, they use simple but biased rules (heuristics) to forecast future output and inflation. Although the rules are biased, agents learn from their mistakes in an adaptive way. Thismodel produces endogenous waves of optimism and pessimism (“animal spirits”) that are generated by the correlation of biased beliefs. I identify the conditions under which animal spirits arise. I contrast the dynamics of this model with a stylized DSGE-version of the model and I study the implications for monetary policies. I find that strict inflation targeting is suboptimal because it gives more scope for waves of optimism and pessimism to emerge thereby destabilizing output and inflation.

Item Type: Article
Official URL: http://www.springer.com/economics/economic+theory/...
Additional Information: © 2011 Springer
Library of Congress subject classification: H Social Sciences > HB Economic Theory
Journal of Economic Literature Classification System: D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D83 - Search; Learning; Information and Knowledge; Communication; Belief
E - Macroeconomics and Monetary Economics > E1 - General Aggregative Models > E10 - General
E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles > E32 - Business Fluctuations; Cycles
Sets: Departments > European Institute
Rights: http://www.lse.ac.uk/library/usingTheLibrary/academicSupport/OA/depositYourResearch.aspx
Date Deposited: 07 Aug 2012 08:17
URL: http://eprints.lse.ac.uk/45124/

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