The Pitfalls of Monetary Discretion

Abstract

In a canonical staggered pricing model, monetary discretion leads to multiple private sector equilibria. The basis for multiplicity is a form of policy complementarity. Specifically, prices set in the current period embed expectations about future policy, and actual future policy responds to these same prices. For a range of values of the fundamental state variable — a ratio of predetermined prices — there is complementarity between actual and expected policy, and multiple equilibria occur. Moreover, this multiplicity is not associated with reputational considerations: it occurs in a two-period model.

Keywords: discretion, time-consistency problem, optimal monetary policy, sticky prices, multiple equilibria

JEL Classification: E52, E51, E58, E31, E42