Can Cold Turkey Reduce Inflation Inertia? Evidence on Disinflation and Level‐k Thinking from a Laboratory Experiment

Abstract

It is widely believed that inflation inertia varies with the policy pursued. In a novel experiment, price setters determine inflation rates and react to a central bank's indicator, which is implemented exogenously either as cold turkey or gradual disinflation. In a third treatment, subjects in the role of a central banker set the indicator endogenously, potentially reducing inertia by signaling to be a tough central banker. I find inertia to be structurally stable and invariant to policies. The data can be organized by a model of level‐k$k$ thinking, which shows that cold turkey improves only a few subjects' adjustment while leaving many behind.