the earlier equilibrium action (1.01, shown in Figure 4) that was appropriate under ex-
treme optimism (α =1). But it is smaller than the equilibrium action appropriate under
extreme pessimism (α =0).
Figure 5 also highlights that the specific values taken on by p0 in the optimistic and
pessimistic equilibrium are endogenously determined in our setup, by current monetary
policy and the sunspot probabilities. By contrast, in the essentially static models of
Albanesi, Chari and Christiano [2002], the values of endogenous variables are not affected
by the probability structure of extrinsic uncertainty.
5.3 Effects of sunspots
Consider now the effects of a sunspot on equilibrium quantities. We take as the reference
point the levels in the low-p0 private-sector equilibrium, which involve a markup of about
1.11 (close to the zero inflation markup) and a normalized price that is close to one.
If the economy suddenly shifts to the high-p0 private sector equilibrium as a result of
the sunspot, then firms become much more aggressive in their adjustments. With the
nominal money stock fixed (Mt = mP1,t-1), there is a decline in real aggregate demand
since the price level rises. Consumption and work effort accordingly fall. Alternatively,
the average markup rises dramatically, increasing distortions in the economy, to bring
about this set of results. Quantitatively, in Figure 5, the rise in the markup is from about
1.12 to about 1.17, so that there is roughly a 4.5% increase in the markup. Given that
markups and consumption are (inversely) related proportionately, there is a 4.5% decline
in consumption and work effort.
6 Relationship to existing monetary policy literature
The study of monetary policy under discretion began with the seminal papers by Kydland
and Prescott [1977] and Barro and Gordon [1983], which we will refer to as KPBG. In
this early literature, output is inefficiently low, but can be raised by policies that also
produce unexpected inflation. There are costs of actual inflation, so that a consistent
equilibrium exhibits an inflation bias. The model that captures these ideas involves
a quadratic monetary authority objective and an economic model consisting of linear
behavioral equations. There is a unique discretionary equilibrium in the standard model
(absent reputational effects or trigger strategies).
In recent years attention has shifted to optimization based models, such as the one
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