Expectation Traps and Monetary Policy
Why is it that inflation is persistently high in some periods and persistently low
in other periods? We argue that lack of commitment in monetary policy may bear a
large part of the blame. We show that, in a standard equilibrium model, absence of
commitment leads to multiple equilibria, or expectation traps. In these traps, expectations
of high or low inflation lead the public to take defensive actions which then make
it optimal for the monetary authority to validate those expectations. We find support
in cross-country evidence for key implications of the model.