Trust and monetary policy

De Grauwe, Paul ORCID: 0000-0001-5225-1301 and Ji, Yuemei (2024) Trust and monetary policy. Journal of Forecasting, 43 (4). 903 - 931. ISSN 0277-6693

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Abstract

We analyze how trust affects the transmission of negative demand and supply shocks using a behavioral macroeconomic model. We define trust to have two dimensions: trust in the central bank's inflation target and trust in the central bank's capacity to stabilize the business cycle. We find, first, that when large negative shocks occur, the subsequent trajectories taken by output gap and inflation typically coalesce around a good and a bad trajectory. Second, these good and bad trajectories are correlated with movements in trust. In the bad trajectories, trust collapses, and in the good trajectories, it is not affected. This feature is stronger when a negative supply shock occurs than in the case of a negative demand shock. Third, initial conditions, in particular the initial state of inflation and output expectations, matter. Unfavorable initial expectations drive the economy into a bad trajectory, and favorable initial expectations produce good trajectories. Fourth, we analyze the sensitivity of our results with respect to the size of the shocks. Fifth, we derive implications of our results for our capacity of making forecasts about the effects of large demand and supply shocks.

Item Type:	Article
Official URL:	https://onlinelibrary.wiley.com/journal/1099131X
Additional Information:	© 2024 The Author(s)
Divisions:	European Institute
Subjects:	H Social Sciences > HB Economic Theory
JEL classification:	E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E52 - Monetary Policy (Targets, Instruments, and Effects) E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles > E32 - Business Fluctuations; Cycles
Date Deposited:	27 Nov 2023 14:24
Last Modified:	12 Dec 2024 03:58
URI:	http://eprints.lse.ac.uk/id/eprint/120871

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