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The role of expectation formation for macroeconomic policy

Esady, V. P. P. (2021). The role of expectation formation for macroeconomic policy. (Unpublished Doctoral thesis, City, University of London)


The overarching theme of this thesis is how information frictions affect expectations formation, and its implications for monetary and fiscal policymaking. Why is that important? Economic agents, such as firms and households, attempt to infer the current state of the economy when making decisions, which is typically not observable in real-time. If their ability to assess current economic conditions (or in economic terms, nowcasts) vary over time, it may affect the way they respond to various shocks, such as monetary and fiscal shocks. I answer this broad question empirically and theoretically. Empirically, I use several methodologies and proxy the degree of information frictions with the Survey of Professional Forecasters — in particular, the dispersion of their nowcasts (‘disagreement’). How can one think of this proxy? A significant amount of disagreement by professional forecasters on a near-term forecast indicates a period of when it is difficult to observe the current state of the economy, or in other words, there is high information rigidities. Theoretically, I explore two styles of information friction models (rational inattention and sticky information) for firms’ price-setting and households’ consumption-saving behaviour. In Chapter 1, I investigate the heterogeneity of monetary policy transmission under time-varying disagreement. Empirically, I establish that during high disagreement periods, prices respond more sluggishly in response to (various measures of) monetary shocks. These stickier prices cause a flatter Phillips curve, leading to the empirical result that monetary policy has stronger real (output) effects. I also develop a tractable theoretical model that show rationally inattentive price-setters produce this result. The rational inattention model contains two theoretical predictions. One, how disagreement across of rationally inattentive price-setters changes when various parameters (that models information frictions) change. Two, how the response of rationally inattentive price-setters to a monetary shock changes when the same parameters change. The rational inattention model also highlights the fundamental differences between uncertainty and disagreement, bridging the results of this chapter with the literature on uncertainty. While there are many models on information frictions to explain its effects on the transmission of monetary shocks, there is surprisingly little on its role on fiscal shocks. In Chapters 2 and 3, I investigate the effects of fiscal shocks on macroeconomic variables and the role of information frictions. Currently, there is still a lack of consensus on how consumption responds to a government spending shock. Typical neoclassical real business cycle (RBC) models predict that consumption should fall to an expansionary government spending shock, but other (more Keynesian) models suggest that consumption rises instead. A key takeaway from this debate is that the forward-lookingness of households is an important determinant of how a government spending shock propagates, as it influences how Ricardian the households are. In Chapter 2, I empirically show that the effects of fiscal policy can be state-dependent due to changes in information frictions. I document a novel result that reconciles the Keynesian and neoclassical predictions of fiscal policy. I use a non-linear local projections framework and combine it with the insights of the previous chapter — using professional forecasters’ disagreement as a measure of information frictions. The key finding is that during periods of high information frictions, households act less Ricardian (as they are less forward-looking), and thus government spending comoves with consumption. In contrast, during low information frictions, households act sufficiently Ricardian such that consumption falls in response to a government spending rise. Another important result highlights that firms and households pay heterogeneous attention to different components of government spending and transfer payment shocks. Thus, fiscal policymakers will benefit from understanding how information frictions affect the decision making process of firms and households in order to use different tools that best achieve their policy goals. In Chapter 3, I provide a theoretical quantitative framework to the empirical findings of Chapter 2, on how information frictions could affect the consumption response to a government spending shock. In particular, I build on a general equilibrium model with sticky information, and add households with limited asset market participation (‘rule-of-thumb’ or ’hand-to-mouth’ households). When information frictions are not severe, many households are able to identify a government spending shock and thus, their Ricardian effects dominate the rule-of-thumb households leading to a fall in aggregate consumption. In contrast, when information frictions impede their ability to identify the shock, only few households save in advance of higher future taxes and therefore, aggregate consumption rises. What can policymakers take away from this thesis? Lower disagreement across agents is ideal when implementing disinflationary monetary policies. Improved central bank communication may help reduce disagreement among economic agents that could lead to a reduction of the sacrifice ratio. In other words, it helps reduce output losses for a given fall in inflation. In addition, expectations formation gives rise to a novel channel of monetary and fiscal policy interaction. Monetary policy has long used communications to shape expectations on future economic conditions. For example, most advanced economy central banks publish some kind of forecast for both inflation and real output. If these communications are successful in influencing expectations — and in particular, decreasing disagreement on future economic conditions — monetary policy communications could reduce the stimulative power of an expansionary fiscal policy shock (and likewise, reduce the output losses of a contractionary fiscal shock). However, note that this is purely a positive, rather than normative, question. If central banks do not communicate sufficiently, it may reduce the effectiveness of monetary policy, which could remain the primary demand-management tool for advanced economies. Additionally, even without the monetary policy benefits, keeping information frictions high could still be welfare sub-optimal. For example, it makes it more difficult for households to smooth consumption in anticipation to all other economic shocks, including fiscal policy.

Publication Type: Thesis (Doctoral)
Subjects: H Social Sciences > HB Economic Theory
Departments: School of Policy & Global Affairs > Economics
School of Policy & Global Affairs > School of Policy & Global Affairs Doctoral Theses
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