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Rational expectations are often used as an argument against policy activism, as they may undermine or neutralize the policymaker’s actions. Although this sometimes happens, rational expectations do not always imply policy invariance or ineffectiveness. In fact, in certain circumstances rational expectations can enhance our power to control an economy over time. In those cases, policy announcements can be used to extend the impact of conventional policy instruments. We present a general forward-looking policy framework and use it to provide a formal rationale for testing when policymakers can and cannot expect to be able to manage expectations. To describe the relevance of our results applications are shown for policy design in small-open economies. Those are the cases where domestic policies are at their weakest and our ability to influence expectations most constrained.

Since the work of Barro, 1974 and Sargent and Wallace, 1975 and Lucas (1976), rational expectations have been regarded as placing severe limits on what can be achieved in a world of policy conflicts; and as requiring strong policy commitments to get even that far. Rational expectations are often said to imply that such commitments cannot be considered credible and to lead inevitably to Pareto inferior outcomes. This argument however does not allow for policymakers who actively engage in managing expectations by making policy announcements, alongside policy interventions, for the express purpose of shifting the expectations path itself.1 If they can do that, private expectations will be exactly consistent with what the private sector/policymakers expect the outcomes to be; and no one will be required to move off their expected path (make expectation errors) for the policies to work. The literature has often used this idea formally and informally in debates over the feasibility and desirability of trying to anchor inflation expectations for monetary policy, or in arguments over the desirability of publishing interest rate forecasts.2 It is also an idea in the minds of the policy makers; see, for example, the European Central Bank’s concern that long term policies introduced to combat the current financial crisis (greater transparency, new regulation, reduced pro-cyclicality, planned liquidity withdrawals) should have their effects now (Trichet, 2008); equally the announcement of new fiscal stimulus or credit guarantee packages. But what the literature has not done is identify the conditions under which we can expect to be able to manage expectations in this way, and their effect on the scope for policy, as opposed to pointing to the possibility and importance of managing expectations. Several recent papers highlight the relevance of these questions. Mertens and Ravn (2010) show, in the context of a specific model, that the impact of any fiscal expansion is part the result of anticipation effects and part genuine impact in the sense normally meant by policy multipliers. But how much, in any particular case, is anticipations and how much is genuine causal impact? Our analysis allows us to answer that question for the general case using the partitioned matrix in (7) below; that is, for any model and without additional estimation uncertainties. In a similar vein, Eusepi and Preston (2010) show that different communication strategies matter in this context – mainly because different strategies have different short and long term effects. Our dynamic analysis allows the policymaker to pick out which strategy, if communicated properly, would have an impact and at which horizon(s) – again for a general model without the parameter restrictions of the original paper; and, conversely, by showing what parameter restrictions must not hold if any communication is to be used successfully. Somewhat more indirectly, Canova and Gambetti (2010) show that expectations can and do get anchored in the sense that their influence does not vary over time even if inflation is changing. But the question remains, how can that happen and what expectations are implied? This paper investigates the circumstances under which policy announcements, if properly communicated, can be used to supplement or extend the impact of conventional policy instruments. The idea is that rational expectations may, in certain cases, enhance the power to control an economy over time. Hence, contrary to conventional wisdom, rational expectations may, but do not always, neutralize the policymaker’s action. Specifically, we consider the design of economic policy within a general rational expectations framework and show that policy invariance can only arise in specific cases (where the unit root or rank conditions specified below fail). In all other cases policy announcements may be used to help steer economic behavior, and certain targets will become reachable in reduced time. The rationale for this result can be understood by using the concept of controllability, introduced in the classical theory of economic policy by Tinbergen (1952), and its dynamic extensions. If a policymaker is able to achieve any desired vector of targets given some exogenous expectations, then he will also be able to do it with endogenous expectations.3 If nothing else, he could exploit the endogenous expectations to achieve his targets in a shorter time. To make use of this property of rational expectations, however, another ingredient must be present. The policymakers must be able to communicate, in a clear and effective manner, the intent and purpose of their policies and how exactly these policies will work. This will be necessary to convince the private sector that the policy measures will in fact be undertaken when it comes to the point; and that it is reasonable to expect that the planned outcomes will be achieved. Otherwise there is no reason to suppose the private sector would shift, or anchor, their expectations of future outcomes as a result of these announcements of future policy actions. Our approach differs from the recent trend in the literature on communication. In our framework, the crucial element is to reaffirm the targets and why the chosen policies can be expected to reach them; as emphasized by Eggertson and Pugsley, 2006, Moessner and Nelson, 2008, Ferrero and Secchi, 2009 and Libich, 2009, and by Woodford’s (2003) observation that policy trade-offs will be eased when expectations fall into line with the chosen policies. By contrast, much of the recent literature on communication has focused on the quality of forecasts, on the degree of divergence or agreement among policy makers, and on transcripts or voting records from policy committees (Ehrmann and Fratzscher, 2005, Ehrmann and Fratzscher, 2007, Jansen and De Haan, 2006 and Visser and Swank, 2007). The rest of the paper is organized as follows. Section 2 poses the communications problem by means of an example drawn from a simple small-open economy (SOE) model with a New Keynesian structure. Section 3 puts this example into a general framework, deriving the reduced and final form of a model with a single policymaker and rational forward-looking expectations. In this section we deal with the conditions for static and dynamic controllability and demonstrate that, contrary to conventional wisdom, dynamic controllability can be enhanced by rational expectations. Our purpose is to identify the circumstances in which controllability is possible; and the conditions when it is not. Section 4 then describes how announcements of future policies can help to ensure static or dynamic controllability of a simple SOE model with forward-looking markets, as described in Section 2, under various assumptions. Section 5 contains a specific illustration of our main point in the context of monetary policy in more complex SOE models. Section 6 concludes.

This paper has examined the ability of policymakers to control a small-open economy, and their ability to steer or anchor private expectations in support of their policies, when agents and financial markets have forward-looking (rational) expectations. We find that the policymakers’ ability to systematically exploit expectations leads to an extension of their policy capability – subject to certain conditions. We provide examples from trade and monetary policy to show when that is possible, and when it is not. Perhaps the most radical departure from conventional wisdom comes with imperfect pass-through; a signal of the importance of that issue for performance and policy design in open economies. Rational expectations have a twofold nature. Since the Lucas critique, the emphasis has been on the implication that the policymaker cannot fool a private sector that correctly anticipates the policies and the equilibrium. This has been done by investigating policy invariance, underlining the role of rational expectations in offsetting the policy interventions. This paper shows that, because policy invariance can only emerge when there is a conflict between the public and the private sector, this will not always be what happens. Policymakers may be able to induce private agents to shift their expectations. Second, rational expectations are also a powerful mechanism, in combination with the chosen policy values, for influencing the natural dynamics of the economy. There has been much less interest in this second aspect of rational expectations which implies that policy announcements may often be used to systematically increase the power of the policymaker’s interventions. A notable exception is Woodford’s timeless perspective, and the use of interest rate forecasts or inflation targets to anchor inflation expectations. In proposition 1, we have obtained a rank condition that defines the circumstances under which rational expectations can be used to increase a policymaker’s power to control an economy over time. It shows how communication and policy announcements can be exploited to supplement and extend the impact of conventional policy instruments. This gives us a formal justification for using policies designed to manage expectations, and defines the circumstances in which expectations cannot be anchored. One implication of this condition is that, in the absence of changes in information, once a policy sequence has been announced there can be no question of revising an announcement for strategic reasons, or of expecting it to be revised, because the policymaker can and is known to be able to reach his first best outcomes. So they have no incentive or interest in not following through on their announcements since it would make them worse off than they need be. In that sense, these policy announcements are all implementable. A second implication is that the quality and credibility of communication by policy makers is a key part of the problem. It is important to examine the conditions that permit effective signaling and commitment, but it is equally important to recognize that there is a whole class of problems for which they are neither necessary nor relevant (although clear communication is still required so that agents can check the consistency of the announced policies and target values). And it will typically be a large class given that we can get down to one instrument and still have controllability if the policy horizon is long enough. This last point then leads four corollaries: a) Successful communication decomposes into two parts; consistency with the announced targets, and clear priorities to signal credibility when there are insufficient instruments or time periods. In the past the literature has concentrated on the second element, neglecting the first. b) Policymakers who are patient can achieve, and be expected to achieve, what goals they want (their first best targets) if they have the time, t ≥ n, or enough instruments. c) Time inconsistent behavior is therefore a limited phenomenon; but will become a problem if policy makers find themselves under pressure and want a quick fix by trying to reach too many targets in too short a time. d) Time inconsistency is not a general or widespread problem. That is a useful conclusion because policymakers appear not make extensive use of it in practice, except perhaps during elections (point c)), and we need to be able to explain why.