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Expectation Traps and Monetary Policy

Staff Report 319 | Published August 1, 2003

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V. V. Chari Consultant
Stefania Albanesi Visiting Scholar, Institute
Expectation Traps and Monetary Policy


Why is inflation persistently high in some periods and low in others? The reason may be absence of commitment in monetary policy. In a standard model, absence of commitment leads to multiple equilibria, or _expectation traps_, even without trigger strategies. In these traps, expectations of high or low inflation lead the public to take defensive actions, which then make accommodating those expectations the optimal monetary policy. Under commitment, the equilibrium is unique and the inflation rate is low on average. This analysis suggests that institutions which promote commitment can prevent high inflation episodes from recurring.

Published in: _Review of Economic Studies_ (Vol. 70, No. 4, October 2003, pp. 715-741)