1 Introduction
In the debate over rules versus discretion for monetary policy, the primary argument
against discretion has been that it leads to higher average inflation than is optimal with
commitment. In the consensus basic model which has developed following Kydland and
Prescott [1977] and Barro and Gordon [1983], the discretionary monetary authority seeks
to produce unexpected inflation to stimulate real output, which is inefficiently low because
of distortions in the economy. But since it cannot fool agents in rational expectations
equilibrium, the discretionary monetary authority produces expected inflation that has a
negligible real effect on output, while imposing other costs on the economy.
By contrast, this paper provides an example of a different, potentially adverse, conse-
quence of discretionary monetary policy: it can lead to multiple equilibria and, thus, to
the possibility of endogenous fluctuations in inflation and real activity that are not related
to the economy’s fundamentals. We illustrate this possibility within a simple dynamic
macroeconomic model that has important New Keynesian features: (i) monopolistic com-
petition, making output inefficiently low; and (ii) a staggered pricing structure in which
firms set nominal prices that must be held fixed for two periods. These two features give
the monetary authority some leverage over real activity.
In this simple setting, the multiplicity of equilibria derives from interaction between
two features of the economy. First, firms adopt forward-looking pricing rules because
their nominal prices are held fixed for two periods. In choosing a price, firms in the
current period need to form expectations about the behavior of the monetary authority
— and firms — in the next period. A higher future money supply leads to a higher future
nominal marginal cost, which raises the optimal price for a firm in the current period.
Second, under discretion, the monetary authority takes as given prices set in previous
periods in determining its choice of the money stock in each period. Since its concern
is to maximize the welfare of the representative agent, which depends on real variables,
it chooses a money stock that is proportional to the price set by firms in the previous
period, which we call a homogenous money stock rule.
The combination of forward-looking pricing with discretionary policy leads to com-
plementarity between the price-setting actions of firms: if all other firms set a higher
price in the current period, the monetary authority will set a higher money supply in the
subsequent period, raising the desired price for a single firm in the current period.
We show that this policy-induced complementarity implies that there are typically