Working Paper: NBER ID: w25404
Authors: Georgemarios Angeletos; Karthik A. Sastry
Abstract: Should policymakers offer forward guidance in terms of a path for an instrument such as interest rates or a target for an outcome such as unemployment? We study how the optimal approach depends on a departure from rational expectations. People have a limited understanding of the behavior of others and of the general equilibrium (GE) effects of policy. The bite of such bounded rationality on implementability and welfare is minimized by target-based guidance if and only if GE feedbacks are strong enough. This offers a rationale for why central banks should shine the spotlight on unemployment when faced with a prolonged liquidity trap, a steep Keynesian cross, or a large financial accelerator.
Keywords: Forward Guidance; Monetary Policy; Expectations; Bounded Rationality; General Equilibrium
JEL Codes: D82; D84; E03; E52; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| choice of communication strategy (L96) | expectations of agents (L85) |
| expectations of agents (L85) | aggregate outcomes (employment and income) (E24) |
| instrument communication (C26) | expectations about interest rates (E43) |
| expectations about interest rates (E43) | aggregate spending (E10) |
| target communication (L96) | expectations about aggregate income (D84) |
| expectations about aggregate income (D84) | spending (H72) |
| strength of GE feedback (D58) | effectiveness of communication strategies (L96) |