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Listen to the Market, Hear the Best Policy Decision, but Don't Always Choose it

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  • Reinstein, David
  • Song, Joon

Abstract

Real-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".

Suggested Citation

  • Reinstein, David & Song, Joon, 2014. "Listen to the Market, Hear the Best Policy Decision, but Don't Always Choose it," Economics Discussion Papers 10008, University of Essex, Department of Economics.
  • Handle: RePEc:esx:essedp:10008
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    1. Breinlich, Holger, 2014. "Heterogeneous firm-level responses to trade liberalization: A test using stock price reactions," Journal of International Economics, Elsevier, vol. 93(2), pages 270-285.
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    4. Ben S. Bernanke & Frederic S. Mishkin, 1997. "Inflation Targeting: A New Framework for Monetary Policy?," Journal of Economic Perspectives, American Economic Association, vol. 11(2), pages 97-116, Spring.
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    6. repec:reg:rpubli:460 is not listed on IDEAS
    7. Prendergast, Canice & Stole, Lars, 1996. "Impetuous Youngsters and Jaded Old-Timers: Acquiring a Reputation for Learning," Journal of Political Economy, University of Chicago Press, vol. 104(6), pages 1105-1134, December.
    8. Kau, James B. & Linck, James S. & Rubin, Paul H., 2008. "Do managers listen to the market?," Journal of Corporate Finance, Elsevier, vol. 14(4), pages 347-362, September.
    9. Michael Spence, 1973. "Job Market Signaling," The Quarterly Journal of Economics, Oxford University Press, vol. 87(3), pages 355-374.
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