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Expectations traps and coordination failures: selecting among multiple discretionary equilibria

  • Richard Dennis
  • Tatiana Kirsanova

Discretionary policymakers cannot manage private-sector expectations and cannot co- ordinate the actions of future policymakers. As a consequence, expectations traps and coordination failures can occur and multiple equilibria can arise. To utilize the explanatory power of models with multiple equilibria it is first necessary to understand how an economy arrives to a particular equilibrium. In this paper, we employ notions of robustness, learnability, and the potential for coalitions to motivate and develop a suite of equilibrium selection criteria. Central among these criteria are whether the equilibrium is learnable by private agents and jointly learnable by private agents and the policymaker. We use two New Keynesian policy models to identify the strategic interactions that give rise to multiple equilibria and to illustrate our equilibrium selection methods. Importantly, although the Pareto-preferred equilibrium is invariably an equilibrium identified by standard numerical iterative solution methods, unless it is learnable by private agents, we find little reason to expect coordination on that equilibrium.

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Paper provided by Federal Reserve Bank of San Francisco in its series Working Paper Series with number 2010-02.

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Date of creation: 2010
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Handle: RePEc:fip:fedfwp:2010-02
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