Expectation Traps and Monetary Policy [report]

Stefania Albanesi, V.V. Chari, Lawrence Christiano
2002 unpublished
Why is it that inflation is persistently high in some periods and persistently low in other periods? We argue that lack of commitment in monetary policy may bear a large part of the blame. We show that, in a standard equilibrium model, absence of commitment leads to multiple equilibria, or expectation traps. In these traps, expectations of high or low inflation lead the public to take defensive actions which then make it optimal for the monetary authority to validate those expectations. We find
more » ... support in crosscountry evidence for key implications of the model. Many countries have gone through prolonged periods of costly, high inflation, as well as prolonged periods of low inflation. Why do high inflation episodes occur? What can be done to prevent them from occurring again? These are two central questions in monetary economics. One tradition for understanding poor inflation outcomes stems from the time inconsistency literature pioneered by Kydland and Prescott (1978) and Barro and Gordon (1983) . This literature points to lack of commitment in monetary policy as the main culprit behind high inflation. Static versions of the models in this literature have a unique equilibrium. Inflation rates can fluctuate only if the underlying fundamentals do. In may cases, it is difficult to see what changes in the underlying fundamentals could have generated the episodes of high and low inflation. In infinite horizon versions of the Kydland-Prescott and Barro-Gordon models, trigger strategies can be used to produce the observed inflation outcomes. However, such models have embarrassingly many equilibria. It is hard to know what observations would be ruled out by such trigger strategy equilibria. This paper is squarely within the tradition of the time inconsistency literature in pointing to lack of commitment as the main culprit behind the observed volatility and persistence of inflation. We make two contributions. First, we show how the economic forces in the Kydland-Prescott and Barro-Gordon models can be embedded into a standard general equilibrium model. Second, we find that once these forces have been embedded into a standard model, inflation rates can be high for prolonged periods and low for prolonged periods, even though we explicitly rule out trigger strategies. We find some support in cross-country data for key implications of the model. In the Kydland-Prescott and Barro-Gordon models, the key trade-off is between the benefits of higher output from unexpected inflation and the costs of realized inflation. In our general equilibrium model, unexpected inflation raises output because some prices are sticky. This rise in output has benefits for households because producers have monopoly power and the unexpected inflation reduces the monopoly distortion. In our general equilibrium model,
doi:10.3386/w8912 fatcat:ktoobcv3dzdshaxga7hjsown5i