EXPECTATION TRAPS AND DISCRETION

We develop a dynamic model with optimizing private agents and a benevo lent, optimizing monetary authority that cannot commit to future polic ies. We characterize the set of sustainable equilibria and discuss the implications for institutional reform. We show that there are equilib ria in which the monetary authority pursues inflationary policies beca use that is what private agents expect. We call such equilibria expect ation traps. Alternative institutional arrangements for the conduct of monetary policy which impose limited forms of commitment on the polic ymaker can eliminate expectation traps. (C) 1998 Academic Press.