Expectations Dynamics: Policy, Announcements and Limits to Dynamic Inconsistency

Economic theory does not have a formal model of how announcements of future policies affect economic performance, or how they could be used to manage expectations. In this paper, we show that, in general, the controllability conditions stated by Tinbergen continue to hold under rational expectations. In fact, we find that when they are satisfied, the presence of rational expectations may even enhance our power to control an economy over time through policy announcements. Good communication is therefore crucial. This is important because it shows that an underlying equilibrium can still exist, even if some traditional policy exercises have been special cases that lead to invariance or time inconsistency. Our paper therefore provides a theoretical justification for the recent literature on anchoring expectations so that monetary policy becomes effective enough to achieve or maintain low inflation.