Managing Asset Price Expectations through Communication

52 Pages Posted: 28 Mar 2024

See all articles by Ehsan Azarmsa

Ehsan Azarmsa

University of Illinois Chicago, College of Business Administration

Johannes Beutel

Deutsche Bundesbank

Date Written: March 21, 2024

Abstract

Behavioral biases in investors' expectations can lead to a decoupling of asset prices from fundamentals, raising the possibility of financial instability. Central bank communication could be a tool to mitigate these issues, but there is no theoretical guidance on how to manage asset price expectations optimally. We fill this gap by developing a model of central bank communication that recognizes investors' behavioral biases. We find optimal communication depends on the way belief formation departs from rationality. It is optimal for central banks to tilt their communication negatively when investors are overreactive to their communication. Full-disclosure is optimal when they under-react or react rationally, even if investors have incorrect prior beliefs. Empirically, we find that most central banks follow the negative-tilt strategy. Our results are robust to dynamic considerations.

Keywords: Behavioral biases, Expectation formation, Information Design

JEL Classification: G01, G14, G18, G40, E44, D53

Suggested Citation

Azarmsa, Ehsan and Beutel, Johannes, Managing Asset Price Expectations through Communication (March 21, 2024). Available at SSRN: https://ssrn.com/abstract=4742965 or http://dx.doi.org/10.2139/ssrn.4742965

Ehsan Azarmsa (Contact Author)

University of Illinois Chicago, College of Business Administration ( email )

University Hall, 601 S Morgan St
Chicago, IL 60654
United States
3122567183 (Phone)

Johannes Beutel

Deutsche Bundesbank ( email )

Wilhelm-Epstein-Str. 14
Frankfurt/Main, 60431
Germany

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