The Optimality of Gradualism in Economies with Financial Markets

Hao Li and Gaowang Wang

MPRA Paper from University Library of Munich, Germany

Abstract: We develop a model economy with active financial markets in which a policymaker's adoption of a gradualistic approach constitutes a Bayesian Nash equilibrium. In our model, the ex ante policy proposal influences the supply side of the economy, while the ex post policy action affects the demand side and shapes market equilibrium. When choosing policies, the policymaker internalizes the impact of her decisions on the precision of the firm-value signal. Moreover, financial markets provide a price signal that informs the government. The policymaker learns about the productivity shocks not only from firm-value performance signals but also from financial market prices. Access to information through both channels creates strong incentives for the policymaker to adopt a gradualistic approach in a time-consistent manner. Smaller policy steps yield more precise information about the productivity shock. These results hold robustly for both exogenous and endogenous information models.

Keywords: gradualistic approach; financial markets; information; learning; optimal policy (search for similar items in EconPapers)
JEL-codes: D83 G10 O2 (search for similar items in EconPapers)
Date: 2025-05-25
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