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Managing Expectations
Robert G. King, Yag K. Lu and Ernesto S. Pasten

Review
The paper focuses on the interplay between private agents and the central bank. The private agent
faces uncertainty regarding behavior of central bank. Hence, we can claim that behavior of central
bank is like a random variable. The central bank is assumed to be of two types; strong type, capable
of making commitments and seeing them through and weak type, capable of discretionary
behavior.
Private agents naturally have expectations or beliefs regarding policies and policy makers find it
in their interest to manage these expectations. Hence, managing of expectations is essential to
monetary policy. Managing expectations takes a critical role when central bank must opt for
optimal policy instruments, describing rationale for policies, such as monetary policies for
disinflation, and during leadership transitions. Furthermore, private agents’ expectations are
closely related to the credibility of central banks.
To examine active management of expectations, economists need a macroeconomic model. The
authors in their paper, ‘Managing Expectations’ provide a framework for systematic study of
managing expectations. The model developed explains three core components of managing
expectations; namely, policy announcements, policy beliefs, and policy actions.
In addition to that, the paper discusses five features critical to managing expectations. Firstly,
private agents are unaware of the behavior of central banks, that is, they do not know if the central
bank will be forthcoming with polices for low and stable inflations. The private agent has
probability that the central bank will be the strong type, which is defined as long term credibility
of central banks. Furthermore, short term credibility is defined as private agent’s likelihood that
central bank will act like a strong type in short term.
If we compare the long term and short term credibility we will find that short term is greater than
long term. This happens because of ‘mimicking’. Mimicking relates to the possibility that the
central bank will act like a strong type and maintain low inflation even though it is not the optimal
strategy.
Moving on, a strong type central bank will influence inflation expectations through announced
policies and use it to manage expectations regarding inflation at a point it time and influence its
long-term credibility in eyes of private agents.
The credibility of banks is imperfect because it is subjected to imitation by weak type of central
banks, i.e. weak central banks will announce the same plan as strong central banks, but will not
execute them. Hence, with low credibility announcements will not have the desired effect.
The general idea of the model can be explained using a subperiod structure as used by the authors.
Before the first period begins, there is transition amongst policymakers. At start of the first period,
a plan 𝑝 is formulated. In the middle, the private agents form expectations of inflation 𝑒, in the end
 Institute of Business Administration, Karachi | Fatima Sadik-05309

of the period, the inflation action 𝜋 is formed. The strong type will see through the plan, while the
weak central bank may choose to deviate or mimic the strong type.
The state variable is defined as the long-term credibility,𝜌, which refers to the start of the period
probability that the central bank is strong type. The long-term credibility is essential for term
structure of interest rates and long term expected inflation. Furthermore, the long-term credibility
evolves as per Bayesian learning.
The authors, have allocated the weak type of central bank a stochastic time discount factor, 𝛽.
Moving on the authors have used dynamic optimization and formed Bellman equations for strong
central banks as well as weak central banks.
𝑉(𝜌, 𝛽) = max{(1 − 𝛿)𝑀 + 𝛿𝐷}
𝑀 = 𝑤(𝑝, 𝑒) + 𝛽𝐸𝛽 𝑉(𝜌′ , 𝛽)

𝐷 = max[𝑤(𝑑, 𝑒) + 𝛽𝐸𝛽 𝑉(0, 𝛽)]

The temptation is defined as:

𝑤(𝑑, 𝑒) − 𝑤(𝑝, 𝑒)
And punishment as:
𝑉(𝜌′ , 𝛽) − 𝑉(0, 𝛽)

The cut off strategy, 𝛽̂ is determined by temptation and punishment as defied above.

𝛿 = 1, 𝜋 = 𝑑(𝑒) 𝑖𝑓 𝛽 ≤ 𝛽̂ (𝑝, 𝑒)

𝛿 = 0, 𝜋 = 𝑝 𝑖𝑓 𝛽 ≥ 𝛽̂ (𝑝, 𝑒)
The weak central bank must decide an optimal level of inflation if it decides to behave in
discretionary manner, 𝑑, then it decides whether it should opt for 𝛿 = 1, i.e. to act in discretionary
manner or 𝛿 = 0, i.e. to mimic.
The Rational Expectation formation leads to fixed point:

𝑒(𝜌, 𝑝) = Ψ(𝜌, 𝑒, 𝑝) + (1 − Ψ(𝜌, 𝑒, 𝑝))𝑑(𝑒)

The three channels for inflation plan expectation management include; direct effect on 𝑒 due to
partial commitments, magnitude of deviation 𝑑(𝑒) via fixed point, and likelihood of carrying out
the plan.
Through Bayesian learning for long term credibility evolution, the long-term credibility grows fast
when short term credibility is low. An aggressive inflation plan lowers mimicking probability.
Also, endogenous mimicking makes plans less effective in lowering expected inflation. The key
trade-off of a more aggressive inflation plan is that larger welfare loss against quicker credibility
gain.
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To understand the trade-off, consider:

Ψ = 𝜌 + (1 − 𝜌)𝑚
Here 𝜌, denotes long term credibility and 𝑚, denotes probability of mimicking. High 𝜌, implies
low impact of changing 𝑚 on 𝜓, which implies less welfare loss. On the other hand, low 𝜌 implies
decreasing the plan may increase 𝑒, which implies substantial welfare loss.
The authors, have developed model in a way that it is easy to add shocks and explain the impact
on credibility and expectations. For instance, shocks induce the weak type central banks to
expropriate the credibility capital and inflation expectations reflect this.
The paper is seminal in its field because, it provides a tractable model in which inflation plan
affects inflation expectations, depending upon credibility of policy makers. The model allows for
study of transition dynamics and evolution of credibility over time.
A possible extension of the paper can accommodate for the fact that not all players have the same
time horizons. Furthermore, the authors have used a Markovian Equilibrium approach which
disregards any cooperation between private agents and policy makers. Also, not just monetary
policy and expectations are closely linked, fiscal policy and expectations also play a crucial part
in any economy. The paper assumes that central bank directly controls inflation, hence the factors
influencing the choice of monetary instrument at a point in time is not considered.