Managing Expectations: Instruments vs. Targets
Should a policymaker offer forward guidance in terms of a path for an instrument such as interest rates or a target for an outcome such as unemployment? We study how the optimal approach depends on bounded rationality. People make mistakes in reasoning about the behavior of others and the equilibrium mapping between policy and outcomes. The policymaker wishes to minimize the effects of such mistakes on implementability and welfare. This goal is achieved by target-based forward guidance if and only if GE feedback is strong enough, as when faced with a prolonged liquidity trap, a steep Keynesian cross, or a large financial accelerator.
Document Object Identifier (DOI): 10.3386/w25404