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Central Bank Balance Sheet Policies Without Rational Expectations

Author

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  • Luigi Iovino
  • Dmitriy Sergeyev

Abstract

We study the effects of central bank balance sheet policies—namely, quantitative easing and foreign exchange interventions—in a model where people form expectations through an iterative level-k thinking process. We emphasize two main theoretical results. First, under a broad set of conditions, central bank interventions are effective under level-k thinking, while they are neutral in the rational expectations equilibrium. Second, when preferences exhibit constant relative risk aversion, asset purchases increase aggregate output if they target assets with pro-cyclical returns but reduce it if asset returns are counter-cyclical. Finally, we empirically show that forecast errors about future asset prices are predictable by balance sheet interventions, a property that differentiates our channel from popular alternatives, such as portfolio-balance and signaling channels.

Suggested Citation

  • Luigi Iovino & Dmitriy Sergeyev, 2023. "Central Bank Balance Sheet Policies Without Rational Expectations," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 90(6), pages 3119-3152.
  • Handle: RePEc:oup:restud:v:90:y:2023:i:6:p:3119-3152.
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    File URL: http://hdl.handle.net/10.1093/restud/rdad010
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    Cited by:

    1. Kopiec, Paweł, 2024. "Monetary-Fiscal Forward Guidance," MPRA Paper 120563, University Library of Munich, Germany.

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