CFS Working Paper No. 2004/22
Monetary Discretion, Pricing Complementarity
and Dynamic Multiple Equilibria*
Robert G. King and Alexander L. Wolman
March 2004
Abstract:
In a plain-vanilla New Keynesian model with two-period staggered price-setting,
discretionary monetary policy leads to multiple equilibria. Complementarity between the
pricing decisions of forward-looking firms underlies the multiplicity, which is intrinsically
dynamic in nature. At each point in time, the discretionary monetary authority optimally
accommodates the level of predetermined prices when setting the money supply because it is
concerned solely about real activity. Hence, if other firms set a high price in the current
period, an individual firm will optimally choose a high price because it knows that the
monetary authority next period will accommodate with a high money supply. Under
commitment, the mechanism generating complementarity is absent: the monetary authority
commits not to respond to future predetermined prices. Multiple equilibria also arise in other
similar contexts where (i) a policymaker cannot commit, and (ii) forward-looking agents
determine a state variable to which future policy responds.
JEL Classification: E5, E61, D78
Keywords: Monetary Policy, Discretion, Time-Consistency, Multiple Equilibria,
Complementarity
*[email protected], Boston University and [email protected], Federal Reserve Bank of Richmond.
This paper is an outgrowth of the authors’ work in progress with Aubhik Khan, available at
http://www.rich.frb.org/pubs/wpapers/pdfs/wp01-8.pdf; it does not necessarily represent the views of the Federal
Reserve System, the Federal Reserve Board, or the Federal Reserve Bank of Richmond. We have benefited from
converstations with Russell Cooper, Huberto Ennis, Mark Gertler, Andreas Horn-stein, Olivier Jeanne, John
Leahy and Henry Siu, and from presentations at Harvard, Iowa, MIT, the New York Fed, UQAM, Western
Ontario, Wharton, York, the conference on Dynamic Models at the Bank of Canada, July 2003, and the
International Research Forum on Monetary Policy, November 2003.