understanding the interaction of the U.S. central bank with the real economy during the
post-war period, one could introduce persistence into the sunspot process determining
equilibrium selection.
7.3 Discretionary policy in other contexts
Our emphasis in this paper has been on the link between lack of commitment for mon-
etary policy and multiple equilibria. However, the nature of the mechanism by which
lack of commitment leads to multiple equilibria suggests that the phenomenon is more
general. Whenever private agents’ forecasts of future policy affect an endogenous state
variable to which future policy responds, there is the potential for policy-induced comple-
mentarity among private agents actions. Just as in our model, even without “structural”
complementarity among private agents, discretionary policy can create complementarity
and lead to multiple equilibria.
A slight modification of Kydland and Prescott’s flood control example fits into this
framework. Suppose private agents choose among two locations, one of which experiences
flooding with positive probability. Agents have idiosyncratic preferences over the two
locations. After agents choose locations, a government chooses whether to impose taxes
and undertake costly flood control. Suppose that the government is willing to let a small
number of inhabitants be flooded, but will undertake flood control if enough agents move
to the flood plain. There can be multiple equilibria here of the sort that arise in our model.
When a single agent believes that no others will move to the flood plain, she knows that
the government will not protect her, and chooses not to locate in the flood plain. When
the agent believes that many others will move to the flood plain, she knows that the
government will protect her, and she chooses to live in the flood plain. Thus, there is
complementarity in agents’ location decisions. That complementarity is not intrinsic,
but is induced by the fact that location decisions determine a state (population in the
floodplain) to which the future policymaker responds. If the policymaker could commit
in advance to its action, it would determine a unique equilibrium.
Another example of lack of commitment leading to multiple equilibria comes from
Glomm and Ravikumar’s [1995] model of public expenditure on education. In their OLG
model, young agents choose how much time to devote to learning, given their expectation
of the income tax rate in the next period. Individual young agents’ decisions in the cur-
rent period determine next period’s individual and aggregate stock of human capital. In
turn, next period’s government chooses the optimal tax rate as a function of the aggregate
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