Coordination of Expectations and the Informational Role of Policy

An informational role of policy arises in economies where large fluctuations are triggered by selffulfilling expectation switches between efficient "optimism" and inefficient "pessimism," a feature that is common in many dynamic economies with coordination failures. Policy affects the information about underlying fundamentals contained in aggregate outcomes, and thus affects the timing of switches and expectations of future switches. As an illustration, we study optimal taxation on labor income in an economy with coordination failures, such that wages and output are ultimately determined by agents’ “optimism” or “pessimism”. Taxes could implement a stabilization policy, but such a policy is ineffective after an expectation switch. Instead, policy should anticipate switches with small permanent tax cuts to extend "optimism" and severe transitory tax cuts to break "pessimism." These tax cuts should be reverted once a switch is triggered, when policy must focus on its short run objectives.