Monetary Discretion, Pricing Complementarity and Dynamic Multiple Equilibria



two private-sector equilibria which can prevail at any point in time and two steady-state
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.

There is a rich literature on the importance of commitment for monetary policy. In
section 6 we relate our analyses to three branches of the existing literature. The first
comprises the seminal works of Kydland and Prescott [1977] and Barro and Gordon
[1983]; they studied reduced-form linear models in which the policymaker had quadratic
preferences, and emphasized that discretion led to inflation bias. The second branch
is associated with the recent optimizing sticky-price models, which have typically been
analyzed using LQ approximations. The emphasis in this work has been on inflation
bias and stabilization bias. Finally, Albanesi, Chari and Christiano [2003] have show
that discretion leads to multiple equilibria in a different kind of sticky price model — one
without the endogenous state variables which play such a crucial role here.

While our results concern an 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. In section 7, we discuss some empirical implications of our model, consider
the consequences of extending it to multiple periods of price-setting, and describe other
potential settings in which similar phenomena might arise. Section 8 concludes.



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