Expectation Traps and Monetary Policy

Embedding the Kydland-Prescott/Barro-Gordon time-inconsistency logic into a standard sticky-price, cash-credit-goods general equilibrium model, this paper shows the resulting model generically has either two Markov equilibria – a high-inflation and a low-inflation one – or none at all, with no trigger strategies (repeated-game punishments) required to sustain the multiplicity. In the model, monopolistically competitive firms produce inefficiently low output; some firms preset prices before the monetary authority chooses the money growth rate, so unanticipated monetary expansion raises output and, because output is inefficiently low to begin with, can raise welfare. Households simultaneously choose, before the money growth rate is set, how much to purchase with previously accumulated cash (costly in forgone interest) versus credit (costly in labor time); realized inflation forces substitution away from cash goods, which lowers welfare. The paper’s key insight is that both sticky-price firms and cash-using households take defensive actions that depend on their expectations of inflation: if either expects high inflation, their optimal defensive response (high preset prices, or lower cash use) lowers the marginal cost to a benevolent monetary authority of actually delivering high inflation, making validation optimal; the reverse defensive choices under low-inflation expectations sustain low inflation instead. The paper proves formally that the model has at least two Markov equilibria whenever it has at least one, labels the resulting persistent multiplicity an “expectation trap,” and shows the two equilibria have starkly different comparative statics: the interest rate’s response to a technology shock switches sign between them, implying the output-interest-rate correlation should be systematically more negative in high-inflation regimes. Examining cross-country and within-country data from the IMF’s International Financial Statistics, the paper finds support for this prediction (correlations of roughly −0.45 versus −0.08 within high-inflation countries’ high- and low-inflation episodes, and −0.33 versus −0.20 across high- and low-inflation countries) as well as for the model’s prediction of higher nominal-variable volatility under high inflation.

Stefania Albanesi | Macro Paper Warehouse

Expectation Traps and Monetary Policy