DP13100 Central Bank Balance Sheet Policies Without Rational Expectations
We study the effects of central bank balance sheet policies—namely, quantitative easing and foreign exchange interventions—in a model where people form expectations through the level-k thinking process, which is consistent with experimental evidence
on the behavior of people in strategic environments. We emphasize two main theoretical results. First, under a broad set of conditions, central bank interventions are effective under level-k thinking, while they are neutral in the rational expectations equilibrium. Second, forecast errors about future endogenous variables are predictable by balance sheet interventions. We confirm these predictions using data on mortgage
purchases by US government sponsored enterprises.