Listen to the Market, Hear the Best Policy Decision, but Don't Always Choose it
AbstractReal-world policymakers want to extract investors private information about a policy's likely effects by listening to "asset markets". However, this brings the risk that investors will profitably "manipulate" prices to steer policy. We model the interaction between a policymaker and an informed (profit-seeking) investor who can buy/short-sell an asset from uniformed traders. We characterize when the investor's incentives do not align with the policymaker's, implying that to induce truth-telling behaviour the policymaker must commit to sometimes ignoring the signal (as revealed by the investor's behaviour driving the asset's price). This implies a commitment to executing the policy with a probability depending on the asset's price. We develop a taxonomy for the full set relationships between private signals, asset values, and policymaker welfare, characterizing the optimal indirect mechanism for each case. We find that where the policymaker is ex-ante indifferent, she commits to sometimes/never executing after a bad signal, but always executes after a good signal. Generically, this "listeneing" mechanism leads to higher (policymaker) welfare then ignoring the signals. We discuss real-world evidence, implications for legislative processes, and phenomena such as "trial balloons" and "committing political capital".
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Bibliographic InfoPaper provided by University of Essex, Department of Economics in its series Economics Discussion Papers with number 748.
Date of creation: 01 Feb 2014
Date of revision:
Postal: Discussion Papers Administrator, Department of Economics, University of Essex, Wivenhoe Park, Colchester CO4 3SQ, U.K.
This paper has been announced in the following NEP Reports:
- NEP-ALL-2014-04-05 (All new papers)
- NEP-CTA-2014-04-05 (Contract Theory & Applications)
- NEP-POL-2014-04-05 (Positive Political Economics)
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- repec:reg:rpubli:460 is not listed on IDEAS
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