Anchoring Expectations of Inflation

This paper studies existence and uniqueness of equilibrium in a monetary model in which fiscal policy is Ricardian. The innovation of the paper is to model agents’ expectations as endogenous probabilities which are determined in equilibrium. Since economies with a Ricardian fiscal policy typically exhibit indeterminacy of equilibrium when the monetary policy instrument is the short-term interest rate, we augment the instruments of monetary policy to the interest rates on a family of bonds of maturities 1, . . . , T and derive conditions under which this ensures uniqueness of equilibrium. We are grateful to participants at the Conference in honor of Andreu Mas-Colell at Barcelona University, the SAET Conference on General Equilibrium at Ischia, the 6th Cowles Conference in General Equilibrium at Yale University and to participants in seminars at Cambridge University, Carnegie-Mellon University, Columbia University, EPGE at the Getulio Vargas Foundation, the Institute for Advanced Studies, Vienna, the Swiss Central Bank, Zurich, the Swiss Finance Institute, University of Zurich, University of California, Santa Cruz, University of Mannheim, University of Lund, University of Rome, and the University of Southern California for helpful comments. All remaining errors are ours. The original paper circulated under the title “Expectations of Inflation, the Term Structure of Interest Rates and Monetary Policy”. Research support from the Swiss Finance Institute is gratefully acknowledged.