The paper proposes a theory of efficient perceptual distortions, in which the statistical relation between subjective perceptions and the objective state minimizes the error of the state estimate, subject to a constraint on information processing capacity. The theory is shown to account for observed limits to the accuracy of visual perception, and then postulated to apply to perception of options in economic choice situations as well. When applied to choice between lotteries, it implies reference-dependent valuations, and predicts both risk-aversion with respect to gains and risk-seeking with respect to losses, as in the prospect theory of Kahneman and Tversky (1979).

The author discusses the U.S. monetary policy proposed and developed by John B. Taylor (1993) within the context of economic theory and economic welfare.

From page 100 -- "A distinctive feature of the procedures recently adopted by inflation-targeting central banks is their forward-looking character. Forecasts of the economy’s future evolution conditional upon alternative policies play a central role in the banks’ deliberations, to an extent that the procedures adopted are sometimes characterized as “forecast targeting.” This emphasis upon the future consequences of policy is unsurprising in an approach that tries to maintain as transparent as possible a relation between the banks’ decisions and the ultimate goals of monetary policy; after all, current decisions can still affect the future, but not the past. Nonetheless, common descriptions of how inflation targeting is or should be practiced go too far, in proposing purely forward-looking procedures. I shall argue instead that an optimal framework for the conduct of monetary policy must generally be history-dependent in ways precluded by these simple proposals. This follows from a general feature of the optimal control of a forward-looking system, which is to say, one in which the private sector’s expectations about future policy are an important determinant of the effects of monetary policy."

From page 382-- "I [the author] wish to argue that the analysis provided by the neoclassical model may not be an adequate guide to policy, even if certain of its predictions are correct. Instead, I [the author] direct attention to an alternative explanation of the effects of changes in the level of public debt, which leads to very different conclusions about the welfare consequences of such policies. According to this view, 'Ricardian equivalence' fails because of imperfect financial intermediation. Some economic units are liquidity constrained, which is to say that they are unable to borrow against their future income at a rate of interest as low as that at which the government borrows. Increased government borrowing can benefit such parties, insofar as they effectively receive a highly liquid asset, government debts, in exchange for giving the government an increased claim on their future income, their own claim to which represented a highly illiquid asset. A higher public debt, insofar as it implies a higher proportion of liquid assets in private sector wealth, increases the flexibility of the private sector in responding to variation in both income and spending opportunities, and so can increase economic efficiency."

It is by now well known that the sort of difference equations that characterize the equilibrium conditions of an infinite horizon competitive economy may have solutions in which the endogenous variables fluctuate in response to "sunspot" variables, that is, to random events that in fact have nothing to do with economic "fundamentals," and so do not directly affect the equilibrium conditions. It is possible to view such "sunspot equilibria" as a representation of an actual phenomenon economic fluctuations not caused by exogenous shocks to fundamentals, but rather by revisions of agents' expectations in response to some event, which revised expectations become self-fulfilling. Early discussions of such solutions sometimes suggested that a more rigorous derivation of the requirements for equilibrium might yield additional restrictions that would eliminate the sunspot solutions from the set of true equilibria. The demonstration by Karl Shell (1977), David Cass (1981), and Costas Azariadis (1981) that sunspot equilibria can exist in a rigorously formulated intertemporal equilibrium model, namely the overlapping generations model of Samuelson, has shown that this is not always the case. Nevertheless, many economists remain skeptical about the reasonableness of the sunspot hypothesis as a possible explanation of actual economic fluctuations, and for quite general reasons, independent of judgments about the empirical plausibility of any particular models. I discuss here three such general reasons for skepticism.

We derive a new cost of information in rational inattention problems, the neighborhood-based cost functions, starting from the observation that many settings involve exogenous states with a topological structure. These cost functions are uniformly posterior separable and capture notions of perceptual distance. This second property ensures that neighborhood-based costs, unlike mutual information, make accurate predictions about behavior in perceptual experiments. We compare the implications of our neighborhood-based cost functions with those of the mutual information in a series of applications: perceptual judgments, the general environment of binary choice, regime-change games, and linear-quadratic-Gaussian settings.

From page 417-- "Economists have long been interested in explaining the observed instability of economic aggregates. Though several reasons for variation in the pace of production are easily given, such as exogenous variation in tastes or in production possibilities, it it hard to see why there should be large variations in those factors that are synchronized across the entire economy. Instead , it seems more likely to suppose that variations in demand or in production costs in different parts of the economy should be largely independent and hence that a law of large numbers would imply that significant variations in aggregate activity (relative to the typical size of aggregate activity) are not likely to occur. ... Here we explore another type of explanation, which relies on an entirely different mechanism. Our proposal is that the effects of many small independent shocks to different sectors of the economy need not cancel out in the aggregate, due to the presence of significantly nonlinear, strongly localized interactions between different parts of the economy. The type of macroscopic instability that can result has been studied by condensed-matter physicists, under the name of 'self-organized criticality' (Per Bak and Kan Chen, 1991)."

We argue that an influential neo-Fisherian analysis of the effects of low interest rates depends on using perfect-foresight equilibrium analysis under circumstances where it is not plausible for people to hold expectations of that kind. We propose an explicit cognitive process by which agents may form their expectations of future endogenous variables. Perfect foresight is justified by our analysis as a reasonable approximation in some cases, but in the case of a commitment to maintain a low nominal interest rate for a long time, our reflective equilibrium implies neither neo-Fisherian conclusions nor implausibly strong predicted effects of forward guidance.

Taken from page 76 -- "The specter of a “liquidity trap,” originally proposed as a theoretical possibility by John Maynard Keynes (1936) but long considered to be of doubtful practical relevance, has recently created alarm among the world’s central banks. In Japan, the overnight rate has been essentially at zero for most of the time since February 1999, making further interest-rate cuts impossible. Yet until well into 2003, growth remained anemic while prices continued to fall, suggesting a need for further monetary stimulus. Since March 2001, the Bank of Japan has supplemented its “zero-interest-rate policy” with a policy of “quantitative easing,” under which additional bank reserves are supplied beyond those needed to keep overnight interest rates at zero. Yet an increase in base money of more than 50 percent failed to halt the deflation, suggesting a liquidity trap. More recently, other central banks, including the Fed, have come close enough to the zero bound to worry about how they would deal with a similar predicament. Here we first discuss whether monetary policy should actually become ineffective when the zero bound on interest rates is reached. We argue that open-market operations, even of “unconventional” types, will be ineffective if they do not change expectations about the future conduct of policy; in this sense, a liquidity trap is possible. Nonetheless, a credible commitment regarding future policy can largely mitigate the distortions created by the zero bound. We fully characterize the optimal commitment in a simple example."