Expectations and fluctuations : the role of monetary policy

How does the economy respond to shocks to expectations? This paper addresses this question within a cashless, monetary economy. A competitive economy features producers and consumers/workers with asymmetric information. Only workers observe current productivity and hence they perfectly anticipate prices, whereas all agents observe a noisy signal about long-run productivity. Information asymmetries imply that monetary policy and consumers’ expectations have real effects. Non-fundamental, purely expectational shocks are conventionally thought of as demand shocks. While this remains a possibility, expectational shocks can also have the characteristics of supply shocks: if positive, they increase output and employment, and lower inflation. Whether expectational shocks manifest themselves as demand or supply shocks depends on the monetary policy pursued. Forward-looking policies generate multiple equilibria in which the role of consumers’ expectations is arbitrary. Optimal policies restore the complete information equilibrium. They do so by manipulating prices so that producers correctly anticipate their revenue despite their uncertainty about current productivity. I design targets for forward-looking interest-rate rules which restore the complete information equilibrium for any policy parameters. Inflation stabilization per se is typically suboptimal as it can at best eliminate uncertainty arising through prices. This offers a motivation for the Dual Mandate of central banks