Monetary Policywith Private Government Preferences: U Turn If You Want To

A common criticism of repeated and dynamic game theoretic models of government policy is that they exhibit a large multiplicity of equilibria making them di cult to test and falsify. Fudenberg-Levine (1989) show that when a large patient player plays against a sequence of short lived players who are uncertain as to the large player's type, the ability of that player to build a reputation may signi cantly reduce the set of supportable equilibrium payo s. This paper explores this idea in the context of a simple computable model of a monetary economy. In the model a population of \small" households does not know the preference type of a \large" government. A benevolent government is one that cares about the households; a \Ramsey playing" government is one that always takes the ex ante optimal monetary policy action along the equilibrium path. It is shown that benevolent governments can build reputations as \Ramsey players". Thus they can drive the equilibrium path of the game towards the Ramsey allocation. A recursive procedure for computing the worst equilibrium payo is provided and it is veri ed that this sort of incomplete information can signi cantly reduce the set of equilibrium payo s. Preliminary and Incomplete! We have received useful comments from participants at seminars at Northwestern University and the Econometric Society Summer Meetings, University of Maryland. All errors are our own.