Federal Reserve Bank of Minneapolis Research Department Equilibrium and Government Commitment

_________________________________________________________________________ How should a government use the power to commit to ensure a desirable equilibrium outcome? In this paper, I show a misleading aspect of what has become a standard approach to this question, and I propose an alternative. I show that the complete description of an optimal (indeed, of any) policy scheme requires outlining the consequences of paths that are often neglected. The specification of policy along those paths is crucial in determining which schemes implement a unique equilibrium and which ones leave room for multiple equilibria that depend on the expectations of the private sector. _____________________________________________________________________________________ *Bassetto, University of Minnesota and Federal Reserve Bank of Minneapolis. I am indebted to Florin Bidian, V. V. Chari, Harold Cole, Russell Cooper, Jeffrey Ely, Larry Jones, Christopher Phelan, and especially Narayana Kocherlakota for useful conversations and advice. I also benefited from comments received at various seminars and conference presentations. Financial support from the National Science Foundation (Grant # 0095766) is gratefully acknowledged. The views expressed herein are those of the author and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. Equilibrium and Government Commitment∗ Marco Bassetto†