Expectations, traps and discretion

Varadarajan Chari, Lawrence Christiano and Martin Eichenbaum

No 96-04, Working Papers in Applied Economic Theory from Federal Reserve Bank of San Francisco

Abstract: 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.

Keywords: Monetary policy; Inflation (Finance) (search for similar items in EconPapers)
Date: 1996
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Citations: View citations in EconPapers (9)

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

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Related works:
Journal Article: Expectation Traps and Discretion (1998)
Working Paper: Expectation traps and discretion (1996)
Working Paper: Expectation Traps and Discretion (1996)
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