equilibria. In general, there is one equilibrium in which firms expect small adjustments
and the newly set price is relatively close to the price that firms set last period. But there
is another in which the adjusting firms make a much larger adjustment.
Because this multiplicity of equilibria arises for arbitrary homogenous monetary poli-
cies, it also arises with an optimizing monetary authority who cannot commit to future
actions. We begin by considering settings of perfect foresight, in which the monetary
authority and private agents each assume that only one of the two types of private sector
equilibria will occur. We show that there are two steady-state discretionary equilibria,
one with low inflation bias and one with high inflation bias. It is notable that the comple-
mentarity which generates multiple equilibria is entirely due, in our model, to the nature
of monetary policy under discretion. That is: our specification of preferences and the la-
bor market is such that there is no complementarity in the price-setting behavior of firms
if the central bank maintains a fixed nominal money stock. Our setup thus highlights the
role of discretionary monetary policy in generating complementarity.
While our results concern the interaction between a monetary policymaker and a
forward-looking private sector that sets prices for only two periods, they are indicative of
a more general phenomenon, both in the context of monetary policy and in other areas
of economics. The necessary features for the kind of phenomenon we describe are as
follows: (i) a policymaker that cannot commit to future actions, and (ii) forward-looking
private agents whose current actions determine a state-variable to which the policymaker
responds in the future. These features seem quite widespread, suggesting that lack of
commitment may be an important cause of economic instability.