Stabilizing Macroeconomic Shocks: Experiments on the Interaction between Central Bank and Private Sector

• Applicant: Professor Dr. Frank Heinemann
• Subject Area: Economic Policy, Applied Economics ; Economic Theory
• Term: from 2013 to 2017
• Project identifier: Deutsche Forschungsgemeinschaft (DFG) - Project number 230406249

Macroeconomists often assume that fluctuations of inflation and employment are associated with social costs. A central bank can use monetary policy to contain fluctuations in a country's inflation and employment rates. In an economy affected by supply shocks, however, the central bank faces a tradeoff between stabilizing inflation and employment. The private sector, on the other hand, can theoretically absorb supply shocks by proper adjustments of wages and prices. Private responses to supply shocks should be more efficient, because they can address asymmetric shocks and relieve the central bank from stabilizing employment, so that it can achieve an efficient stabilization of inflation. But, price and wage adjustments are associated with a coordination problem, because prices in different sectors are strategic complements and the optimal response to an exogenous shock depends on the responses of other private agents. Central banks have the ability of solving the coordination problem by affecting product demand via the interest rate. However, monetary policy can just address aggregate shocks and may crowd out private responses that are, however, necessary for convergence to equilibrium after asymmetric shocks. We, thus, identify two sources of interactions:- Strategic substitution between central bank's stabilization policy and private sector's reaction: there is a conflict between the central bank and the private sector, since active stabilization is costly, although both parties benefit from stabilizing employment. - Strategic complementarity between actions of private sector's agents: wage or price adjustments to macroeconomic shocks in one sector raise the incentives to adjust wages or prices in other sectors of the economy.In this research project, we will use laboratory experiments to generate data on a game that follows a modern macro model. The advantage of this approach is that we can implement different policy regimes in treatments that are otherwise equal and, thus, isolate the effects of transparency, cheap talk, and commitments to rules. Our specific research question is which policy regimes are best-suited to resolve the conflict of interests between central bank and a decentralized private sector in stabilizing employment and minimize the welfare costs of exogenous shocks.

• DFG Programme: Research Grants
• International Connection: France
• Participating Person: Professorin Dr. Camille Cornand