Expectations Traps and Monetary Policy with Limited Commitment

We study the existence and uniqueness properties of monetary policy with limited commitment in LQ RE models. We use a New Keynesian model with debt accumulation in the spirit of Leeper (1991) as a 'lab', because this model generates multiple equilibria under pure discretion, and under full commitment there are two distinct determinate regimes. We study how these properties change over the continuum of intermediate cases between commitment and discretion. We find that although multiple equilibria exist for high degrees of precommitment, even a small degree of precommitment selects a unique equilibrium for a wide range of parameters. We discuss the stability properties of policy equilibria which can be used to design an equilibrium selection criterion. We also demonstrate very different welfare implications for different policy equilibria