This paper develops a theory of expectations-driven business cycles based on learning. Agents have incomplete knowledge about how market prices are determined and shifts in expectations of future prices affect dynamics. Learning breaks the tight link between fundamentals and equilibrium prices, inducing periods of erroneous optimism or pessimism about future returns to capital and wages which subsequent data partially validate. In a real business cycle model, the theoretical framework amplifies and propagates technology shocks. Moreover, it produces agents' forecast errors consistent with business cycle properties of forecast errors for a wide range of variables from the Survey of Professional Forecasters. JEL: C53, D83, D84, E32, E37

This paper provides theory and evidence that distorted long-term interest rate expectations limit the effectiveness of monetary policy. Beliefs that depart from rational expectations break the tight link between policy rates and long-term interest rates, even when determined by the expectations hypothesis of the yield curve. Because long-term expectations are excessively sensitive to short-term interest rates, optimal policy is less aggressive relative to rational expectations. More aggressive policy leads to suboptimal volatility in long-term interest rates and aggregate demand through standard intertemporal substitution effects. These effects are quantitatively important in the United States over the postwar period.