average forecast across agents of a macroeconomic variable responds slowly to news. if a shock raises inflation for some time, the average forecast of inflation increases by less than inflation itself. moreover, the average forecast error in a crosssection of agents is likely to be of the same sign as the ex ante revision in the average forecast. if inflation is rising and forecasts tend to be revised up, the average forecast error is likely to be positive – people are likely to under - predict inflation. this is, of course, in contrast to the theory of full - information rational expectations, where forecast errors are unpredictable. the same pattern is present in the data for survey - based and market - based measures of inflation expectations, for expectations of macroeconomic variables other than inflation, among consumers and professional economists, and in different countries. 3 ricardo, together with gregory mankiw, developed a theory that accounts for the salient features of the data on expectations. 4 in the sticky information model of mankiw and reis, economic agents update their information only sporadically. when agents fail to update, they make decisions based on information that is to some extent out of date. the updating is staggered across the population, so that at any one time some people are paying attention to news, while others remain inattentive. as a result, information diffuses gradually in the economy. the average forecast responds slowly to news, as in the data. each individual makes the best forecast given their information. at the same time, however, the average forecast error across agents can be predicted by the ex ante revision in the average forecast, as in the data. finally, again in line with 1 / 4 bis central bankers'speeches the data, agents in the model disagree, because their information sets differ. in sum, the sticky information model suggests how expectations are actually formed in the real world. a number of interesting policy implications arise from this more real - world account of expectation formation. as ricardo showed in a paper with lawrence ball and gregory mankiw, optimal monetary policy – given productivity and demand shocks – is price level targeting, as opposed to inflation targeting. 5 this is a controversial proposition with practical inconveniences that render it unpopular among central bankers. there have thus been no attempts to implement it. a broader lesson for monetary policy resulting from the analysis is that long - term inflation expectations are likely to be more stable in a sticky - information world. central bankers will probably find this message

of the underlying causes. markus brunnermeier ’ s research has played a prominent role here. for instance, his research on bubbles sheds light on how institutional frictions and strategic considerations can lead to significant mispricings of assets. 2 while market participants may be aware of the flawed asset valuation, the lack of common knowledge can lead to a build up of the bubble and hinder its bursting. this approach departs from the conventional market efficiency view that rational traders will immediately stabilise prices by shortening overvalued assets and, by contrast, integrates important aspects of trading behaviour into the mainstream of economics and finance. when a bubble bursts and risk is re - assessed, financial institutions suffer losses. in the current crisis, uncertainty over the size and location of exposures of banks or banksponsored conduits to “ toxic ” assets translated into funding liquidity problems. a paper by brunnermeier and pedersen, “ market liquidity and funding liquidity ” explains how such funding problems can affect market liquidity and lead to mutually reinforcing liquidity spirals. 3 balance sheet constraints of financial intermediaries can naturally lead to market illiquidity and the expectations of future liquidity risk can lead to panic and more asset price declines. indeed, liquidity shortage was one of the key propagation mechanisms of the current crisis which illustrates a negative externality that fire - sales by individual institutions can impose on the financial system as a whole. it is also one of the factors that contributed to prolonged tensions in the interbank market as banks were reluctant to lend to each other to minimise counterparty exposures. these markets are crucial for banks ’ liquidity managements and also for the transmission of monetary policy. the work on funding and market liquidity also offers possible mechanisms for the resolution of liquidity spirals. the key policy prescription is to improve the funding liquidity of financial institutions in order to prevent solvent institutions from being driven out of business by protracted illiquidity. this policy has been followed extensively by the eurosystem over the recent past. liquidity spirals also create an important pro - cyclical mechanism in the financial system. this issue is discussed in the draft notes on the next geneva report on the world economy written by professor brunnermeier and co - authors on “ the fundamental principles of financial abreu, d. and m. brunnermeier ( 2003 ), “ bubbles and crashes ”