Discretionary Policy and Multiple Equilibria in a New Keynesian Model

Abstract

Focusing on linear-quadratic models with rational expectations, this paper extends the concept of discretionary equilibrium by allowing for linear non- Markovian strategies of the policy-maker and the other agents in the economy. Applying this concept to the standard New Keynesian framework, we show that a multitude of equilibria arise. Some equilibria have favorable consequences for welfare, resulting in outcomes superior even to those achieved under timelessperspective commitment. Compared to traditional approaches to modeling credibility through trigger strategies, our approach has the desirable implication that small mistakes of the policy-maker have only small consequences for his reputation. Finally, we show that our equilibrium concept can provide an alternative explanation for the high degree of inflation persistence found in the data.