Managing Asset Return Expectations through Communication

Abstract

Behavioral biases in investors' expectations can lead to a decoupling of asset prices from fundamentals, and risks to financial stability. Central bank communication could be a tool to mitigate these issues, but there is no theoretical guidance on how and when  to communicate  when some investors do not form expectations rationally. We develop a communication model that flexibly accounts for such deviations from rationality and allows for heterogeneity in investors' belief formation. We find that in the presence of these heterogeneities, communication may hinder risk-sharing  and lead to over- or under-production of risky assets.  Full disclosure is optimal only when investors update their beliefs in a way that is sufficiently homogeneous and close to the rational benchmark. Otherwise, no disclosure is optimal. Our results further suggest that it is more effective to communicate during normal periods, before investors' beliefs become too entrenched. We also discuss the effectiveness of communication relative to other policy tools, such as interest rate and macroprudential policies.

Keywords: Behavioral biases, Expectation formation, Information Design

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