How to manage expectations

Our main lesson is that, in the presence of this friction [a bound on the depth of the agents’ knowledge and rationality], offering guidance in terms of targets rather than instruments is preferable when and only when the GE feedback is sufficiently strong. In practical terms, policymakers should put more weight on communicating a commitment to an unemployment or output growth target when the economy enters a prolonged liquidity trap, when the Keynesian cross is steep, or when the financial accelerator is large. In a sense we make precise, such a policy “maximizes confidence,” or minimizes the distortion caused by bounded rationality.

Using a novel news-topic-based approach we show that news types the media choose to report on, e.g., fiscal policy, health, and politics, are good predictors of households’ stated inflation expectations. In turn, in a noisy information model setting, augmented with a simple media channel, we document that the underlying time series properties of relevant news topics explain the time-varying information rigidity among households.