Managing Expectations

Abstract

Should a policymaker manage expectations by offering forward guidance in terms of the likelyvalue of a future policy instrument or a target for an equilibrium outcome such as aggregate output?We study how the optimal approach depends on plausible bounds on agents’ depth of knowledgeand rationality. Agents make mistakes in predicting, or reasoning about, the behavior of others andthe GE effects of policy. The optimal communication strategy minimizes the bite of such mistakeson implementability and welfare. This goal is achieved by offering guidance in terms of an outcometarget rather than a policy value if and only if the GE feedback is strong enough. Our results suggestthat central banks should stop talking about interest rates and start talking about unemploymentwhen faced with a steep Keynesian cross or a prolonged liquidity trap.