Central Bank Balance Sheet Policies Without Rational Expectations

Luigi Iovino and Dmitriy Sergeyev

The Review of Economic Studies, 2023, vol. 90, issue 6, 3119-3152

Abstract: We study the effects of central bank balance sheet policies—namely, quantitative easing and foreign exchange interventions—in a model where people form expectations through an iterative level-k thinking process. We emphasize two main theoretical results. First, under a broad set of conditions, central bank interventions are effective under level-k thinking, while they are neutral in the rational expectations equilibrium. Second, when preferences exhibit constant relative risk aversion, asset purchases increase aggregate output if they target assets with pro-cyclical returns but reduce it if asset returns are counter-cyclical. Finally, we empirically show that forecast errors about future asset prices are predictable by balance sheet interventions, a property that differentiates our channel from popular alternatives, such as portfolio-balance and signaling channels.

Keywords: Balance sheet policies; Bounded rationality (search for similar items in EconPapers)
Date: 2023
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Persistent link: https://EconPapers.repec.org/RePEc:oup:restud:v:90:y:2023:i:6:p:3119-3152.

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