This paper argues for a careful (re)consideration of the expectations formation process and a more systematic inclusion of real-time expectations through survey data in macroeconomic analyses. While the rational expectations revolution has allowed for great leaps in macroeconomic modeling, the surveyed empirical micro-evidence appears increasingly at odds with the full-information rational expectation assumption. We explore models of expectation formation that can potentially explain why and how survey data deviate from full-information rational expectations. Using the New Keynesian Phillips curve as an extensive case study, we demonstrate how incorporating survey data on inflation expectations can address a number of otherwise puzzling shortcomings that arise under the assumption of full-information rational expectations.
The Inattentive Consumer: Sentiment and Expectations
Expectations are central to macroeconomic models. Despite this, the belief formation process is not well understood. Using survey data, I show that consumers’ economic beliefs are driven by one component: sentiment. Surprisingly, “optimistic” consumers expecting an expansion also predict disinflation, contrasting with recent U.S. experience. I explain these facts with a model of rationally inattentive consumers who face fundamental uncertainty. Optimal information-gathering implies consumers reduce the dimensionality of the problem, obtaining a signal that is a linear combination of fundamentals. This information compression implies the covariances of beliefs systematically differ from the data-generating process; specifically, price beliefs become countercyclical.
Uncertainty and Optimal Monetary Policy (with Joshua Bernstein)
PDF - Preliminary, comments welcome!
We study optimal monetary policy in a New Keynesian model in which the policy maker faces uncertainty about the economy. Uncertainty creates stochastic deviations between the policy maker’s expectations and the truth, which cause endogenous and stochastic macroeconomic fluctuations in equilibrium. Relative to the full information benchmark, output responds less to supply shocks but more to demand shocks. Severe enough uncertainty causes equilibrium indeterminacy. Quantitatively, output and inflation are positively correlated under the optimal policy, in contrast to full-information policies that prescribe either price stability or leaning against the wind.
Polarized Expectations (with Walker Ray)
This paper explores the role of political polarization in shaping the economic expectations of households. Using survey data, we find that the rise in political polarization has led to polarized beliefs about macroeconomic fundamentals. We then develop a rational inattention model in which heterogeneous households choose from where to get their information. We show that an increasing number of information sources leads to growing ex-post disagreement about economic fundamentals, even when these sources are unbiased. Further, under general conditions there is a "paradox of information" where falling information costs exacerbates disagreement.
The Securitization and Solicited Refinancing Channel of Monetary Policy
I propose and document the "securitization and solicited refinancing channel," a novel transmission mechanism of monetary policy and its heterogenous regional effects. The hypothesis is that mortgage lenders who sell their originations to Government Sponsored Enterprises (GSEs) or into securitizations no longer hold the loan's prepayment risk, and when rates drop, these lenders are more likely to signal to their borrowers to refinance, resulting in more borrower refinancing. A regression analysis finds that in response to decline in mortgage-backed security (MBS) yields, regions where originate-to-sell-or-securitize lenders operate see more refinancing activity than regions where originate-to-hold lenders operate. The findings have important implications for (i) the efficacy of policy to increase refinancing, lower mortgage payments, and stimulate demand, (ii) the distributional consequences of monetary policy, and (iii) how the GSEs and securitization may play a key role in the pass-through to the housing market.
On November 8, 2016, India demonetized all outstanding 500 and 1,000 rupee notes, removing 86% of cash in circulation. New 500 and 2,000 rupee notes were eventually issued, but the process of printing and distribution took longer than anticipated. The motive for demonetization was to crack down on counterfeiting and money laundering and, as such, was unrelated to the state of the Indian macro-economy. Therefore, Indian demonetization can serve as a unique natural experiment to study the real effects of monetary shocks, price rigidities, and relative substitution patterns following a liquidity crunch. This project uses disaggregated data on prices and quantities of different consumption categories across regions in India to study these topics. Our results suggest that the prices of agricultural goods responded strongly and somewhat persistently to demonetization; however, the household consumption response was more muted.