Policy Design and Operation in a Macroeconomic Model with a Managed Exchange Rate under Different Expectational Regimes

An investigation of the problems of policy formation has to take account of the way in which expectations may be formed. The assumption of rationality is often made on the grounds that there is no reason to assume that views of the future display any particular bias. Some authors take this further, arguing that it is unwise to adopt policies which would only work if they were misunderstood by the public. However it is equally important that policies should not rely on rationality to be successful; any policy package should be tested for robustness under a variety of expectational regimes. Here we discuss methodological issues of policy design and application under rational expectations; we then go on to demonstrate the effects of a particular policy package on a model of the British economy, derived from version 7 of the National Institute (NIESR) model, suitably modified so as to allow the identification of expectational effects in financial markets. This allows a much more thorough analysis of financial policy than was available to Vines, Maciejowski and Meade in their earlier work. We consider the effectiveness of a policy designed under an assumption of rationality, but applied to an economy in which financial markets are adaptive. The analysis is carried out on the assumptions that wage behaviour is governed by an inflation-augmented Phillips curve and that the exchange rate is managed.