The Role of Expectations in Stabilization Policy

This paper develops and tests a theory of the process by which private agents in an economy form expectations about government policy. Agents form and update their beliefs about the true state of government policy in a Bayesian fashion. The ‘credibility ’ of a policy is defined to be the subjective probability that the government is pursuing a ‘reform ’ policy rule. The ‘credibility ’ of a reform of monetary or exchange rate policies is a function of the parameters of both monetary and fiscal policies. The theory is applied to the Chilean and Argentine exchange reforms of the late 1970’s. 1