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Discretionary policy and multiple equilibria

  • Robert G. King

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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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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  1. 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.
  2. 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.
  3. Cooper,Russell, 1999. "Coordination Games," Cambridge Books, Cambridge University Press, number 9780521578967.
  4. Russell Cooper & Andrew John, 1988. "Coordinating Coordination Failures in Keynesian Models," The Quarterly Journal of Economics, Oxford University Press, vol. 103(3), pages 441-463.
  5. Robert G. King & Alexander L. Wolman, 2004. "Monetary Discretion, Pricing Complementarity, and Dynamic Multiple Equilibria," The Quarterly Journal of Economics, Oxford University Press, vol. 119(4), pages 1513-1553.
  6. V. V. Chari & Lawrence J. Christiano & Martin Eichenbaum, 1996. "Expectation Traps and Discretion," NBER Working Papers 5541, National Bureau of Economic Research, Inc.
  7. Chamley, Christophe, 1986. "Optimal Taxation of Capital Income in General Equilibrium with Infinite Lives," Econometrica, Econometric Society, vol. 54(3), pages 607-22, May.
  8. King, Robert G. & Wolman, Alexander L., 2004. "Monetary discretion, pricing complementarity and dynamic multiple equilibria," CFS Working Paper Series 2004/22, Center for Financial Studies (CFS).
  9. 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.
  10. Cooper,Russell, 1999. "Coordination Games," Cambridge Books, Cambridge University Press, number 9780521570176.
  11. 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.
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