Created 2/21/1996
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Expectational Traps and Discretion


Comments on V.V. Chari, Lawrence J. Christiano, and Martin Eichenbaum, "Expectational Traps and Discretion"

for the 1996 Stanford CEPR and Federal Reserve Bank of San Francisco conference on Monetary Policy: Measurement and Management

Brad DeLong

Associate Professor of Economics, 601 Evans
University of California at Berkeley
Berkeley, CA 94720-3880
(510) 643-4027 phone; (510) 642-6615 fax

The Model

The model is nicely done: monopolistically-competitive producers of intermediate goods who exercise their monopoly power to set prices "too high" for social welfare maximization. But they can--in theory, but not on average in equilibrium--be fooled by unexpected monetary expansions into producing at closer to the social optimum. Offsetting these benefits to unanticipated inflation is inflation's action as a distorting tax on employment: anticipated inflation benefits nobody.

As a result, it is painful, employment-reducing, and welfare-decreasing for a government to ever let money grow at less than its anticipated value--except to the extent that lowered money growth reduces expectations of future money and inflation growth. And it is employment-enhancing and welfare-increasing for a government to boost money growth to higher than its anticipated value--except to the extent that higher money growth today creates expectations that such higher growth will continue.


Suppose that positive deviations of money growth from anticipated values trigger permanent expectations of vastly higher inflation, while negative deviations of money growth from anticipated values do not reduce expectations of future inflation. Then we have a central banker's worst nightmare. A period-by-period welfare-maximizing government will find itself straining every muscle to hit the monetary growth mark set by whatever private-sector expectations happen to be. The government desperately tries to avoid exceeding inflationary expectations because of the terrible consequences for future expectations, and desperately tries to avoid undershooting on monetary growth because it causes unemployment yet does no good at lowering expectations of future inflation.

These equilibria, in which the benevolent government finds itself forced to satisfy private-sector expectations of higher inflation are the ones that Chari, Christiano, and Eichenbaum focus on.


They suggest that these particular expectational trap equilibria provide a stylized look at one of the powerful mechanisms that gave the U.S. a decade of higher inflation in the 1970s. Is this accurate?

Medium Term Financial Strategy

So can we see Chari, Christiano, and Eichenbaum's model in operation? I think we can. Think of the British Conservative government, and the Medium Term Financial Strategy it had adopted at the end of the 1970s. The MTFS was a set of money stock growth rate targets for the next n years, gradually declining from rates of growth consistent with the high British inflation of the late 1970s to price stability. The idea was that the government would hit the first monetary growth target or two--and that would convince private-sector economic actors that the government meant it. Their expectations of future money growth would change, and their expectations of future money growth would fall.

Since the disinflation would be gradual, you would not have the unpleasant situation in which money growth in year t was very low when a lot of economic contracts were still based on expectations of year t money growth formed in year t-3 when year t growth was expected to be high. You would get very close to costless disinflation, and you would do so even in a John Taylor overlapping-contracts world. Your firm commitment to a gradualist disinflationary policy would ensure that there was never any large negative gap between actual inflation and the "expected" rate of inflation that had been frozen into place by the temporal contracting structure of the economy.

But the MTFS did not unfold according to plan. You see, one of the major issues that the Conservative Party had used to defeat Labour in the elections of the late 1980s was unemployment. Billboards all over the country showing lots of people standing in an unemployment benefit line. Text underneath: "Labour isn't working." Implied promise: more jobs--and lower unemployment--under a Conservative government.

Disinflation--especially in its early stages, when it runs into an economy in which lots of prices and contracts in force had been made under the assumption that disinflation was not going to happen--is not a big employment-generating policy. So the Conservative Party began to drop in the polls. And as it dropped in the polls, people began to think "these guys--the current government--mean it, but they are not going to be around for very long; someone more left-leaning is almost certain to win the next election and restoke the engine of inflation. And maybe a coup within the Conservative Party will transfer power to the 'wet' faction." So the longer the MTFS continued, the less credible it became--and the less people thought that current low money growth heralded future low money growth.

Tom Sargent wrote a very good paper on this in the early 1980s, comparing the disinflationary methods of Margaret Thatcher unfavorably to those of pre-World War II French Premier Raymond Poincare. Its point was that what was done gradually can be undone gradually--and hence is unlikely to be credible. But I think that Thatcher's difficulties were caused much more by the peculiar shape of British politics than by any theoretical defect in a long-term and fully credible version of policies like the MTFS.

In the end Thatcher was rescued by Argentinian generals, and by suicidal divisions among her political opponents who hated each other more than they cared about winning elections. And the Conservative governments of the 1980s did have time to convince British economic decision makers that, yes, low money growth does herald low money growth in the future. But between the Conservative election victories of the late 1970s and the Falklands War we can see Britain's macroeconomy unfolding along a path eerily similar to that of the model in Chari, Christiano, and Eichenbaum.


And this brings me to my final point. Chari, Christiano, and Eichenbaum use their model to argue--as was first expressed in these terms by Kydland and Prescott--that a commitment technology is a wonderful thing. The entire expectational dance of the private sector forming views and the monetary authority not daring to do anything other than validate them could be avoided, if only there could be commitment to a stable monetary policy rule.

This point is very true, but it is also dangerous--as Britain before the Falklands War shows.


So I find myself both more and less optimistic than Chari, Christiano, and Eichenbaum. More optimistic, in that the kind of expectational trap they assume seems to me to be found only rarely in our world. Less optimistic, in that the credible commitment technology they hope to use as a cure does not seem to me to be found at all.


Created 2/21/1996
Go to
Brad DeLong's Home Page

Professor of Economics J. Bradford DeLong, 601 Evans
University of California at Berkeley; Berkeley, CA 94720-3880
(510) 643-4027 phone (510) 642-6615 fax