Horizon-Biased Expectations in New Keynesian Models: Resolving Forward Guidance without Ad Hoc Discounting

Cassella, Golez, Gulen, and Kelly (2021) document that professional forecasters become increasingly optimistic as forecast horizons lengthen—a robust “horizon bias.” Yet much of the macro literature still treats expectations as either rational or uniformly bounded (e.g., simple discounting or level-k). Building on Bersson, Hürtgen, and Paustian (2023), who show that level-k expectations avoid forward guidance and reversal puzzles at the ZLB, this project proposes a different micro-departure: a horizon-dependent distortion in belief formation. Concretely, agents’ expectations for near-term variables are close to rational or level-k, but long-horizon beliefs tilt toward the target or “good news,” consistent with motivated beliefs theory (Benabou-style mechanisms discussed by Cassella et al.). We then re-derive optimal policy and impulse responses in a NK model with this multi-horizon belief operator and test whether it jointly fits: (i) muted effects of very long-dated guidance, (ii) realistic fiscal multipliers at the ZLB (Bersson et al.), and (iii) survey term-structure of inflation expectations. This departs from Milani’s survey-based expectation models (2012) by introducing systematic horizon-dependence rather than uniform departures from RE. It also sharpens Rotemberg’s (2015) critique by offering a concrete mechanism behind the statistical failures of RE models on forward guidance. The payoff is a disciplined behavioral wedge that is both survey-calibrated and policy-relevant, potentially reshaping how we design and evaluate communication that targets distant horizons.

References:

1. Interpreting the Statistical Failures of Some Rational Expectations Macroeconomics Models. J. Rotemberg (2015).
2. Expectations Formation, Sticky Prices, and the ZLB. Elizabeth Bersson, P. Hürtgen, Matthias O. Paustian (2023). Social Science Research Network.
3. Horizon Bias in Expectations Formation. S. Cassella, Benjamin Golez, Huseyin Gulen, Peter Kelly (2021).
4. Expectation Formation and Monetary DSGE Models: Beyond the Rational Expectations Paradigm. Fabio Milani, A. Rajbhandari (2012).
5. The Modeling of Expectations in Empirical DSGE Models: a Survey. Fabio Milani (2012).
6. Expectations Formation, Sticky Prices, and the ZLB. Elizabeth Bersson, P. Hürtgen, Matthias O. Paustian (2023). Social Science Research Network.