Optimal Policy Without Rational Expectations: A Sufficient Statistic Solution

No 1011, Working Papers from University of Florida, Department of Economics

Abstract: How should policymakers respond to mistakes made by agents without rational expectations? I demonstrate in a general setting that the optimal policy is determined by a sufficient statistic: agents' belief distortion or "sentiment". This result is both simple and only semi-structural: in order to calculate policy from the sentiment, the policymaker does not need to know the whole macroeconomic model. They only need to know how sentiments and policies distort decisions. Crucially, they do not even need to know how expectations are formed; they only need to measure them. Next, I study several examples. In a behavioral RBC model, the optimal policy is to tax capital when agents are overly optimistic about future returns. In a behavioral New Keynesian model, the optimal policy is raise interest rates when agents misperceive the economy to be running hot. I conclude by arguing for policymakers to focus on estimating sentiments in the data.

JEL-codes: E52 E61 E70 (search for similar items in EconPapers)
Date: 2024-02
New Economics Papers: this item is included in nep-dge
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