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Expectations, traps and discretion

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

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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Paper provided by Federal Reserve Bank of San Francisco in its series Working Papers in Applied Economic Theory with number 96-04.

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Date of creation: 1996
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Publication status: Published in Monetary Policy: Measurement and Management : a conference (1996: March 1) ; Journal of Economic Theory, August 1998, Vol. 81, no. 2, p 462-492
Handle: RePEc:fip:fedfap:96-04
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  1. Laurence Ball, 1991. "The genesis of inflation and the costs of disinflation," Proceedings, Federal Reserve Bank of Cleveland, pages 439-461.
  2. Laurence M. Ball, 1990. "Time-Consistent Policy and Persistent Changes in Inflation," NBER Working Papers 3529, National Bureau of Economic Research, Inc.
  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. Martin Eichenbaum & Lawrence J. Christiano, 1992. "Liquidity Effects, Monetary Policy, and the Business Cycle," NBER Working Papers 4129, National Bureau of Economic Research, Inc.
  5. repec:nbr:nberre:0126 is not listed on IDEAS
  6. Benhabib, Jess & Farmer, Roger E.A., 1996. "Indeterminacy and Sector-Specific Externalities," Working Papers 96-12, C.V. Starr Center for Applied Economics, New York University.
  7. Azariadis, Costas, 1981. "Self-fulfilling prophecies," Journal of Economic Theory, Elsevier, vol. 25(3), pages 380-396, December.
  8. Kiminori Matsuyama, 1990. "Increasing Returns, Industrialization and Indeterminacy of Equilibrium," Discussion Papers 878, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  9. David Backus & John Driffill, 1984. "Inflation and Reputation," Working Papers 560, Queen's University, Department of Economics.
  10. V.V. Chari & Patrick J. Kehoe, 1989. "Sustainable plans," Staff Report 122, Federal Reserve Bank of Minneapolis.
  11. V.V. Chari & Patrick J. Kehoe, 1989. "Sustainable plans and mutual default," Staff Report 124, Federal Reserve Bank of Minneapolis.
  12. V.V. Chari & Patrick J. Kehoe, 1989. "Sustainable plans and debt," Staff Report 125, Federal Reserve Bank of Minneapolis.
  13. Christiano, Lawrence J & Eichenbaum, Martin & Evans, Charles, 1996. "The Effects of Monetary Policy Shocks: Evidence from the Flow of Funds," The Review of Economics and Statistics, MIT Press, vol. 78(1), pages 16-34, February.
  14. Alan S. Blinder, 1982. "The Anatomy of Double-Digit Inflation in the 1970s," NBER Chapters, in: Inflation: Causes and Effects, pages 261-282 National Bureau of Economic Research, Inc.
  15. 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.
  16. Taylor, John B, 1980. "Aggregate Dynamics and Staggered Contracts," Journal of Political Economy, University of Chicago Press, vol. 88(1), pages 1-23, February.
  17. Arthur F. Burns, 1978. "Reflections of an Economic Policy Maker," Books, American Enterprise Institute, number 725136, 5.
  18. Cass, David & Shell, Karl, 1983. "Do Sunspots Matter?," Journal of Political Economy, University of Chicago Press, vol. 91(2), pages 193-227, April.
  19. Lucas, Robert Jr, 1976. "Econometric policy evaluation: A critique," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 1(1), pages 19-46, January.
  20. Bryant, John, 1983. "A Simple Rational Expectations Keynes-Type Model," The Quarterly Journal of Economics, MIT Press, vol. 98(3), pages 525-28, August.
  21. Barro, Robert J. & Gordon, David B., 1983. "Rules, discretion and reputation in a model of monetary policy," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 101-121.
  22. V.V. Chari, 1988. "Time consistency and optimal policy design," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 17-31.
  23. Bewley, Truman, 1983. "A Difficulty with the Optimum Quantity of Money," Econometrica, Econometric Society, vol. 51(5), pages 1485-504, September.
  24. Stokey, Nancy L., 1991. "Credible public policy," Journal of Economic Dynamics and Control, Elsevier, vol. 15(4), pages 627-656, October.
  25. Harold L. Cole & Timothy J. Kehoe, 1998. "Self-Fulfilling Debt Crises," Levine's Working Paper Archive 114, David K. Levine.
  26. Abreu, Dilip, 1988. "On the Theory of Infinitely Repeated Games with Discounting," Econometrica, Econometric Society, vol. 56(2), pages 383-96, March.
  27. Calvo, Guillermo A, 1978. "On the Time Consistency of Optimal Policy in a Monetary Economy," Econometrica, Econometric Society, vol. 46(6), pages 1411-28, November.
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