Expectation traps in a new Keynesian open economy model

Abstract

This paper illustrates that the presence of a money demand distortion in an otherwise standard new Keynesian open economy model results in multiple discretionary equilibria that arise in the form of expectations traps. If private sector inflation expectations become sufficiently unanchored, the model predicts that a monetary authority can easily be trapped into validating these expectations, thereby pushing the economy to a lower welfare equilibrium. Given the ease with which expectation traps arise in the presence of international linkages, the main result presented here suggests that maintaining well-anchored inflation expectations is a critically important policy goal for central banks in open economies.