Finance and Economics Discussion Series (FEDS)
August 2004
Expectation Traps in a New Keynesian Open Economy Model
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.
Keywords: Discretionary monetary policy, expectation traps, Friedman rule, time consistency problem
PDF: Full Paper
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