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Discretionary policy and multiple equilibria

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  • Robert G. King

Abstract

Discretionary policymaking can foster strategic complementarities between private sector decisions, thus leading to multiple equilibria. This article studies a simple example, originating with Kydland and Prescott, of a government which must decide whether to build a dam to prevent adverse effects on floods on the incomes of residents of a floodplain. In this example, it is socially inefficient to build the dam and for people to live on the floodplain, with this outcome being the unique equilibrium under policy commitment. Under discretion, there are two equilibria. First, if agents believe that few of their fellow citizens will move to the floodplain, then they know that the government will choose not to build the dam and there is therefore no incentive for any individual to locate on the floodplain. Second, if agents believe that there will be many floodplain residents, then they know that the government will choose to build the dam and even small benefits of living on the floodplain will lead them to choose that location. In this second equilibrium, all individuals are worse off.

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Bibliographic Info

Article provided by Federal Reserve Bank of Richmond in its journal Economic Quarterly.

Volume (Year): (2006)
Issue (Month): Win ()
Pages: 1-15

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Handle: RePEc:fip:fedreq:y:2006:i:win:p:1-15:n:v.92no.1

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Keywords: Monetary policy ; Equilibrium (Economics);

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  1. Chari, V. V. & Christiano, Lawrence J. & Eichenbaum, Martin, 1998. "Expectation Traps and Discretion," Journal of Economic Theory, Elsevier, vol. 81(2), pages 462-492, August.
  2. Robert G. King & Alexander L. Wolman, 2004. "Monetary discretion, pricing complementarity, and dynamic multiple equilibria," Working Paper 04-05, Federal Reserve Bank of Richmond.
  3. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
  4. Barro, Robert J & Gordon, David B, 1983. "A Positive Theory of Monetary Policy in a Natural Rate Model," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 589-610, August.
  5. Cooper, Russell & John, Andrew, 1988. "Coordinating Coordination Failures in Keynesian Models," The Quarterly Journal of Economics, MIT Press, vol. 103(3), pages 441-63, August.
  6. Lindbeck, Assar & Weibull, Jorgen W., 1993. "A model of political equilibrium in a representative democracy," Journal of Public Economics, Elsevier, vol. 51(2), pages 195-209, June.
  7. Fischer, Stanley, 1980. "Dynamic inconsistency, cooperation and the benevolent dissembling government," Journal of Economic Dynamics and Control, Elsevier, vol. 2(1), pages 93-107, May.
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Cited by:
  1. Huberto M. Ennis & Todd Keister, 2009. "Bank Runs and Institutions: The Perils of Intervention," American Economic Review, American Economic Association, vol. 99(4), pages 1588-1607, September.
  2. Ennis, Huberto M. & Keister, Todd, 2010. "Banking panics and policy responses," Journal of Monetary Economics, Elsevier, vol. 57(4), pages 404-419, May.
  3. Huberto M. Ennis, 2005. "Complementariedades y Política Macroeconómica," Department of Economics, Working Papers 054, Departamento de Economía, Facultad de Ciencias Económicas, Universidad Nacional de La Plata.
  4. Todd Keister & Huberto M. Ennis, 2007. "Commitment and Equilibrium Bank Runs," 2007 Meeting Papers 509, Society for Economic Dynamics.

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