Gonzalo Cisternas and Aaron Kolb

Expectations can play a significant role in driving economic outcomes, with central banks factoring market sentiment into policy decisions and market participants forming their own assumptions about monetary policy. But how well do central banks understand the expectations of market participants—and vice versa? Our model, developed in a recent paper, features a dynamic game between (i) a monetary authority that cannot commit to an inflation target and (ii) a set of market participants that understand the incentives created by that credibility problem. In this post, we describe the game, a type of Keynesian beauty contest: its main novelty is that each side attempts, with varying degrees of accuracy, to forecast the other’s beliefs, resulting in new findings regarding the levels and trajectories of inflation.