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Expectation Traps and Discretion

  • Chari, V. V.
  • Christiano, Lawrence J.
  • Eichenbaum, Martin

We argue that discretionary monetary policy exposes the economy to welfare-decreasing instability. It does so by creating the potential for private expectations about the response of monetary policy to exogenous shocks to be self-fulfilling. Among the many equilibria that are possible, some have good welfare properties. But, others exhibit welfare decreasing volatility in output and employment. We refer to the latter type of equilibria as expectation traps. In effect, our paper presents a new argument for commitment in monetary policy because commitment eliminates these bad equilibria. We show that full commitment is not necessary to achieve the best outcome, and that more limited forms of commitment suffice.

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Article provided by Elsevier in its journal Journal of Economic Theory.

Volume (Year): 81 (1998)
Issue (Month): 2 (August)
Pages: 462-492

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Handle: RePEc:eee:jetheo:v:81:y:1998:i:2:p:462-492
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/622869

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  1. Roger E.A. Farmer & Jang Ting Guo, 1992. "Real Business Cycles and the Animal Spirits Hypothesis," UCLA Economics Working Papers 680, UCLA Department of Economics.
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  3. Lawrence J. Christiano & Martin Eichenbaum, 1992. "Liquidity effects, monetary policy, and the business cycle," Discussion Paper / Institute for Empirical Macroeconomics 70, Federal Reserve Bank of Minneapolis.
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  14. Kiminori Matsuyama, 1990. "Increasing Returns, Industrialization and Indeterminacy of Equilibrium," Discussion Papers 878, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
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