Keywords: Discretionary monetary policy, expectation traps, Friedman rule, time consistency problem
Abstract: This paper illustrates that the introduction of a money demand distortion
into an otherwise standard New Keynesian Open Economy model generates
multiple discretionary equilibria. These equilibria arise in the form of expectations
traps whereby the monetary authority is trapped into validating
expectations of the private sector because failing to do so is costly. One implication
of the model is that provided initial inflation expectations are sufficiently
anchored the global Friedman rule emerges as an equilibrium under discretion.
It is therefore a time-consistent outcome and hence fully sustainable even in
absence of a commitment device or reputational considerations.
Full paper (878 KB PDF)
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Last update: August 26, 2004