contexts in which discretion can lead to multiple equilibria because of policy-induced
complementarity among private agents.
7.1 Greater Price Stickiness
Multiplicity of equilibrium under discretion is not an artifact of two-period staggered pric-
ing. The key model element generating multiplicity is the existence of a nominal state
variable (here, the nominal price set by firms that adjusted their price in the previous
period). With prices set for more than two periods, such a nominal state variable would
still exist, but it would be an index of those nominal prices charged in the current period
but chosen in previous periods. Furthermore, there would be real state variables, namely
ratios of the current period nominal prices chosen by firms in previous periods. Solving
for an equilibrium under discretion is more complicated when there is a real state that
constrains the monetary authority. In Khan, King and Wolman [2001], we show that
multiple equilibria still arise with three-period staggered pricing. However, that analysis
is conducted using backward induction on a finite horizon model, and already with a two
period horizon we encounter some headaches. There are discontinuities in the monetary
authority’s policy functions, which makes it computationally difficult — though not im-
possible — to extend the horizon beyond two periods. For this reason we chose to focus
here on the model without a state variable, where we are able to characterize equilibrium
with an infinite horizon.
7.2 Empirical implications
There are tantalizing empirical implications of the kind of model we have discussed here.
First, a model with multiple steady state rates of inflation can potentially explain why
monetary policymakers can be caught at a high rate of inflation, in what Chari, Christiano
and Eichenbaum [1998] call an “expectations trap.” This could explain wide variation in
inflation rates across countries or time periods displaying similar structural features.
Second, the effect of sunspots on economic activity that we just discussed in section 5.3
is a situation of “unexpected stagflation” arising because of shifting beliefs. Goodfriend
[1993] describes post-war U.S. recessions as arising from “inflation scares”, situations in
which markets suddenly come to expect higher inflation and a contraction in aggregate
demand occurs. The effect that we describe above seems to capture some aspects of this
perspective, but it does not involve the increases in long-term expectations of inflation
reflected in market interest rates. To consider such effects, which may be important for
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