Expectation traps and discretion

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