Discretionary Policy and Multiple Equilibria in a New Keynesian Model
38 Pages Posted: 4 Apr 2014
Date Written: April 2014
This paper extends the concept of discretionary equilibrium for linear-quadratic models with rational expectations by allowing for linear non-Markovian strategies of the policy-maker and the other agents in the economy. Applying this concept to the standard New Keynesian framework, we show that a multitude of equilibria arise. Some equilibria have favorable consequences for welfare, resulting in outcomes superior even to those achieved under timeless-perspective commitment. Compared to traditional approaches to modeling credibility through trigger strategies, our approach has the desirable implication that small mistakes of the policy-maker have only small consequences for his reputation. Finally, we show that our equilibrium concept can provide an alternative explanation for the high degree of inflation persistence found in the data.
Keywords: New Keynesian model, multiple equilibria, discretionary equilibrium, inflation persistence, reputation
JEL Classification: E31, E52, E58, C61
Suggested Citation: Suggested Citation