Working Paper

Expectation traps and discretion


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: Rational expectations (Economic theory); Monetary policy;

Authors

    Christiano, Lawrence J.

    Eichenbaum, Martin

    V.V. Chari

Bibliographic Information

Provider: Federal Reserve Bank of Chicago

Part of Series: Working Paper Series, Macroeconomic Issues

Publication Date: 1996

Number: WP-96-5