A General Theory (and Some Evidence) of Expectation Traps in Monetary Policy

Authors


  • I would like to thank Jordi Gali, Amartya Lahiri, as well as the editor and two referees for comments. Eleanor Dillon provided excellent research assistance. The views expressed here are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System.

Abstract

I show that multiple equilibria are a general property of economies under full monetary policy discretion. Three simple conditions are sufficient to rule out, generically, a unique equilibrium in a static economy. The key departure from Barro and Gordon (1983) is to consider bounded welfare costs of inflation. I also show that in a two Markov equilibrium economy the inflation response to certain perturbations is, generically, qualitatively different in each equilibrium. Finally, I discuss some evidence on inflation dynamics that supports the hypothesis that U.S. monetary policy was caught in an expectation trap during the high inflation episode of the 1970s.

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