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Monetary Discretion, Pricing Complementarity and Dynamic Multiple Equilibria

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  • Robert G. King
  • Alexander L. Wolman

Abstract

In a plain-vanilla New Keynesian model with two-period staggered price-setting, discretionary monetary policy leads to multiple equilibria. Complementarity between the pricing decisions of forward-looking firms underlies the multiplicity, which is intrinsically dynamic in nature. At each point in time, the discretionary monetary authority optimally accommodates the level of predetermined prices when setting the money supply because it is concerned solely about real activity. Hence, if other firms set a high price in the current period, an individual firm will optimally choose a high price because it knows that the monetary authority next period will accommodate with a high money supply. Under commitment, the mechanism generating complementarity is absent: the monetary authority commits not to respond to future predetermined prices. We compute a traditional inflation bias equilibrium, in which price-setters are optimistic, rationally expecting small adjustments by other firms. But there is another steady-state equilibrium in which price setters are pessimistic and inflation is much higher. Further, we find that there are multiple equilibria at a point in time, not just in steady states. In a stochastic setting with equilibrium selection each period determined by an i.i.d. sunspot, there is greater inflation bias on average than if price-setters were always optimistic. The sunspot realization also has real effects: periods of higher than average inflation are accompanied by low output. Thus, increased real volatility may be an additional cost of discretion in monetary policy.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 9929.

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Date of creation: Aug 2003
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Publication status: published as King, Robert G. and Alexander L. Wolman. "Monetary Discretion, Pricing Complementarity, and Dynamic Multiple Equilibria," Quarterly Journal of Economics 119(4): 1513-1553, November 2004
Handle: RePEc:nbr:nberwo:9929

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  9. 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.
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  13. Glomm, Gerhard & Ravikumar, B., 1996. "Endogenous public policy and multiple equilibria," European Journal of Political Economy, Elsevier, vol. 11(4), pages 653-662, April.
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  15. Robert King & Alexander L. Wolman, 1999. "What Should the Monetary Authority Do When Prices Are Sticky?," NBER Chapters, in: Monetary Policy Rules, pages 349-404 National Bureau of Economic Research, Inc.
  16. Aubhik Khan & Robert G. King & Alexander L. Wolman, 2001. "The pitfalls of monetary discretion," Working Paper 01-08, Federal Reserve Bank of Richmond.
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