Central Bank Balance Sheet Policies without Rational Expectations (joint with 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 process known as level-k thinking. This process is consistent with experimental evidence of the behavior of people who are confronted with novel strategic situations. This choice of belief formation process is motivated by the fact that some balance sheet policies are novel while others are still not well understood. 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, forecast errors about future endogenous variables are predictable by balance sheet interventions. We confirm these predictions using data on the mortgage purchases by United States government sponsored enterprises as a proxy for quantitative easing.