The Informational Content of Prices When Policy Makers React to Financial Markets
59 Pages Posted: 5 Jul 2014 Last revised: 6 Dec 2015
Date Written: December 5, 2015
I analyze settings where a policy maker needs information that financial market traders have in order to implement her optimal policy, and market prices may reveal this information. Policy decisions, in turn, affect asset values, possibly punishing the informed for trading on information. Applications include central bank policy reactions to asset prices or regulator reactions to bond prices. In the first part without noise, I derive a necessary and sufficient condition for the possibility of fully revealing equilibria, which identifies all situations where learning from prices for policy purposes works, and where it does not. Full revelation may be impossible because the pricing problem is a self-defeating prophecy, impairing incentives to trade on information. I demonstrate how the condition can be used for asset design that supports information revelation by markets. In the second part, I develop a noisy model of trader-policy maker interaction. Noise can solve the problem of self-defeating prophecies in specific situations, but in general it may still occur. Using a novel solution approach, I derive a necessary and sufficient condition for the existence of revealing equilibria in a general class of noisy equilibria that allows for nonlinear price and policy functions.
Keywords: Asymmetric Information, Financial Markets, Policy, Policy Risk, Rational Expectations Equilibrium, Self-Defeating Prophecy
JEL Classification: D53, D82, D84, G10
Suggested Citation: Suggested Citation