, Volume 47, Issue 2-3, pp 423-457

Animal spirits and monetary policy

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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. This model 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.

This research was supported by a grant of the European Commission (POHLIA). I am grateful to Yunus Aksoy, Tony Atkinson, Stephan Fahr, Daniel Gros, Richard Harrison, Romain Houssa, Pablo Rovira Kaltwasser, Christian Keuschnigg, Alan Kirman, Giovanni Lombardo, Lars Ljungqvist, Patrick Minford, John Muellbauer, Ilbas Pelin, Frank Smets, Leopold von Thadden, David Vines, and Tony Yates for their comments and suggestions on previous versions of this paper. I am also indebted to an anonymous referee whose comments and suggestions have led to significant improvements.