Abstract
This paper investigates the effectiveness of central bank communication when firms have heterogeneous inflation expectations that are updated through social dynamics. The bank's credibility evolves with these dynamics and determines how well its announcements anchor expectations. We show that trying to eliminate high inflation by abruptly introducing a low inflation target can lead to short-term overshooting whereas gradually introducing the target directs the economy to the long-term goal more quickly and smoothly. In contrast, avoiding a protracted deflation requires aggressive announcements that could more easily be accommodated under price-level targeting. For an inflation targeting central bank, we find that varying two dimensions of quantitative easing - number of rounds and intensity of announcements - provides an effective way to stem deflationary expectations without altering inflation targets.
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