Discretionary Policy and Multiple Equilibria in LQ RE Models

We study discretionary equilibria in dynamic linear-quadratic rational expectations models. In contrast to the assumptions that pervade this literature we show that these models do have multiple equilibria in some situations. We investigate general properties of discretionary equilibria. We demonstrate that for multiple equilibria to exist, models must have some `history dependence' that implies sluggish adjustment. This creates possibility to have different but mutually consistent beliefs of economic agents about the future speed of stabilization. Multiple equilibria are likely to occur, in particular if there are complementarities in the model. We demonstrate the existence of multiple discretionary equilibria by example. In a simple New Keynesian model of optimal monetary policy, but with fiscal solvency constraint, monetary policy can be either `active' or `passive' in the sense of Leeper (1991), depending on the strength of fiscal control of debt. There is an intermediate strength of fiscal control when both active and passive policies are possible.