Expectation Traps and Discretion

39 Pages Posted: 19 Aug 1996  

Varadarajan V. Chari

University of Minnesota - Twin Cities - Department of Economics; Federal Reserve Bank of Minneapolis; National Bureau of Economic Research (NBER)

Lawrence J. Christiano

Northwestern University; Federal Reserve Bank of Cleveland; Federal Reserve Bank of Chicago; Federal Reserve Bank of Minneapolis; National Bureau of Economic Research (NBER)

Martin Eichenbaum

Northwestern University; National Bureau of Economic Research (NBER)

Date Written: April 1996

Abstract

We argue that discretionary monetary policy exposes the economy to welfare-decreasing instability. It does so by creating the potential for private expectations about the response of monetary policy to exogenous shocks to be self-fulfilling. Among the many equilibria that are possible, some have good welfare properties. But others exhibit welfare-decreasing volatility in output and employment. We refer to the latter type of equilibria as expectation traps. In effect, our paper presents a new argument for commitment in monetary policy because commitment eliminates these bad equilibria. We show that full commitment is not necessary to achieve the best outcome, and that more limited forms of commitment suffice.

Suggested Citation

Chari, Varadarajan V. and Christiano, Lawrence J. and Eichenbaum, Martin, Expectation Traps and Discretion (April 1996). NBER Working Paper No. w5541. Available at SSRN: https://ssrn.com/abstract=3248

Varadarajan V. Chari

University of Minnesota - Twin Cities - Department of Economics ( email )

271 19th Avenue South
1108 Management & Economics
Minneapolis, MN 55455
United States
612-626-7151 (Phone)

Federal Reserve Bank of Minneapolis ( email )

90 Hennepin Avenue
Minneapolis, MN 55480
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Lawrence J. Christiano

Northwestern University ( email )

2003 Sheridan Road
Evanston, IL 60208
United States
847-491-8231 (Phone)
847-491-7001 (Fax)

Federal Reserve Bank of Cleveland

East 6th & Superior
Cleveland, OH 44101-1387
United States

Federal Reserve Bank of Chicago

230 South LaSalle Street
Chicago, IL 60604
United States

Federal Reserve Bank of Minneapolis

90 Hennepin Avenue
Minneapolis, MN 55480
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Martin Eichenbaum (Contact Author)

Northwestern University ( email )

2003 Sheridan Road
Evanston, IL 60208
United States
847-491-8232 (Phone)
847-491-7001 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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