Should policy communications aim at anchoring expectations of the policy instrument ("keep interest rates at zero until date τ") or of the targeted outcome ("do whatever it takes to bring unemployment down to $y\%$")? We study how the optimal approach depends on a departure from rational expectations. People have limited depth of knowledge and rationality, or form otherwise distorted beliefs about the behavior of others and the general equilibrium (GE) effects of policy. The bite of this distortion on implementability and welfare is minimized by target-based guidance if and only if GE feedback is 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.
All Science Journal Classification (ASJC) codes
- Economics and Econometrics