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Inflation illusion and the Taylor principle: An experimental study

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  • Luhan, Wolfgang J.
  • Scharler, Johann
Abstract
We develop a simple experimental setting to evaluate the role of the Taylor principle, which holds that the nominal interest rate has to respond more than one-for-one to fluctuations in the inflation rate to exert a stabilizing effect. In our setting, the average inflation rate fluctuates around the inflation target if the computerized central bank obeys the Taylor principle. If the Taylor principle is violated, the average inflation rate persistently deviates from the target. These deviations from the target are less pronounced, if inflation rates cannot be as readily observed as nominal interest rates. This result is consistent with the interpretation that subjects underestimate the influence of inflation on the real return to savings if the inflation rate is only observed ex post.

Suggested Citation

  • Luhan, Wolfgang J. & Scharler, Johann, 2014. "Inflation illusion and the Taylor principle: An experimental study," Journal of Economic Dynamics and Control, Elsevier, vol. 45(C), pages 94-110.
    • Handle: RePEc:eee:dyncon:v:45:y:2014:i:c:p:94-110
    DOI: 10.1016/j.jedc.2014.05.006
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    Cited by:

    1. Camille Cornand & Frank Heinemann, 2018. "Experiments on macroeconomics: methods and applications," Working Papers 1810, Groupe d'Analyse et de Théorie Economique Lyon St-Étienne (GATE Lyon St-Étienne), Université de Lyon.
    2. Camille Cornand & Frank Heinemann, 2014. "Experiments on Monetary Policy and Central Banking," Research in Experimental Economics, in: Experiments in Macroeconomics, volume 17, pages 167-227, Emerald Group Publishing Limited.
    3. Abraham Lioui & Andrea Tarelli, 2023. "Money Illusion and TIPS Demand," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 55(1), pages 171-214, February.
    4. Cornand, Camille & Hubert, Paul, 2020. "On the external validity of experimental inflation forecasts: A comparison with five categories of field expectations," Journal of Economic Dynamics and Control, Elsevier, vol. 110(C).
    5. Camille Cornand & Paul Hubert, 2020. "On the external validity of experimental inflation forecasts," SciencePo Working papers Main hal-02894262, HAL.
    6. Camille Cornand & Frank Heinemann, 2018. "Experiments on macroeconomics: methods and applications," Working Papers halshs-01809937, HAL.
    7. Kenichi Tamegawa, 2024. "Inflation response in a New Keynesian model with money illusion," Bulletin of Economic Research, Wiley Blackwell, vol. 76(2), pages 529-544, April.

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    More about this item

    Keywords

    Taylor principle; Interest rate rule; Inflation illusion; Laboratory experiment;
    All these keywords.

    JEL classification:

    • E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • C90 - Mathematical and Quantitative Methods - - Design of Experiments - - - General

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