Expectations Driven Fluctuations and Stabilization Policy∗

This paper explores the constraints imposed by expectations formation on the effectiveness of stabilization policy. Agents have incomplete information about the economic environment and form beliefs by extrapolating from observed patterns in historical data. Regimes with Ricardian fiscal policy (as in the standard account of monetary policy design) and also non-Ricardian fiscal policy are considered. In both cases macroeconomic stabilization requires tighter coordination of fiscal and monetary policy than under a rational expectations analysis. However, the latter is demonstrated to be more robust in the sense that under learning dynamics they are less prone to self-fulfilling expectations. Furthermore, economies with Ricardian fiscal policies are shown to be more stable the higher the degree of nominal rigidities in price setting. For non-Ricardian regimes, the converse is true. In all regimes, instability is mitigated by central bank communication of the monetary policy rule. However, regardless of the fiscal policy regime, economy’s with higher average debt to output ratios tend to be prone to expectations driven instability. Hence, even in Ricardian regimes the precise choice of fiscal policy – in terms of its steady state implications – will be relevant to expectations stabilization. These findings are all in direct contrast to the predictions of a rational expectations equilibrium analysis of the model. ∗The views expressed in the paper are those of the authors and are not necessarily reflective of views at the Federal Reserve Bank of New York or the Federal Reserve System. The usual caveat applies. †Department of Economics, Columbia University, 420 West 118th St. New York NY 10027. E-mail: [email protected]