Managing Expectations without Rational Expectations

George-Marios Angeletos and Karthik Sastry
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Karthik Sastry: Massachusetts Institute of Technology

No 1537, 2019 Meeting Papers from Society for Economic Dynamics

Abstract: Should a policymaker offer forward guidance by committing to a path for the policy instrument or a target for an equilibrium outcome? We study how the optimal approach depends on plausible bounds on agents’ depth of knowledge and rationality. Agents make mistakes in predicting, or reasoning about, the behavior of others and the GE effects of policy. The optimal policy minimizes the bite of such mistakes on implementability and welfare. This goal is achieved by fixing and com- municating an outcome target if and only if the GE feedback is strong enough. Our results suggest that central banks should stop talking about interest rates and start talking about unemployment when faced with a steep Keynesian cross or a prolonged liquidity trap.

Date: 2019
New Economics Papers: this item is included in nep-cba and nep-upt
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