Forward Guidance without Common Knowledge
Forward guidance—and macroeconomic policy more generally—relies on shifting expectations, not only of future policy, but also of future economic outcomes such as income and inflation. These expectations matter through general-equilibrium mechanisms. Recasting these expectations and these mechanisms in terms of higher-order beliefs reveals how standard policy predictions hinge on the assumption of common knowledge. Relaxing this assumption anchors expectations and attenuates the associated general-equilibrium effects. In the context of interest, this helps lessen the forward-guidance puzzle, as well as the paradox of flexibility. More broadly, it helps operationalize the idea that policy makers may find it hard to shift expectations of economic outcomes even if they can easily shift expectations of policy.
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Document Object Identifier (DOI): 10.3386/w22785
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