Expectation Traps and Discretion

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

NBER Working Paper No. 5541
Issued in April 1996
NBER Program(s):   EFG

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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Published: Journal of Economic Theory, Vol. 81, no. 2 (August 1998): 462-492

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