Discretionary Policy and Multiple Equilibria

15 Pages Posted: 8 Dec 2012

See all articles by Robert G. King

Robert G. King

Boston University - Department of Economics; Federal Reserve Bank of Richmond - Research Department; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: 2006

Abstract

Discretionary policymaking can foster strategic complementarities between private sector decisions, thus leading to multiple equilibria. This article studies a simple example, originating with Kydland and Prescott, of a government that must decide whether to build a dam to prevent adverse effects of floods on the incomes of floodplain residents. In this example, it is socially inefficient to build the dam and for people to live on the floodplain, with this outcome being the unique equilibrium under policy commitment. Under discretion, there are two equilibria. First, if agents believe that few of their fellow citizens will move to the floodplain, then they know that the government will choose not to build the dam, and there is therefore no incentive for anyone to locate there. Second, if agents believe that there will be many floodplain residents, they know that the government will choose to build the dam, and even small benefits of living on the floodplain will lead them to choose that location. In this second equilibrium, all individuals are worse off.

Suggested Citation

King, Robert G., Discretionary Policy and Multiple Equilibria (2006). FRB Richmond Economic Quarterly, vol. 92, no. 1, Winter 2006, pp. 1-15, Available at SSRN: https://ssrn.com/abstract=2186147

Robert G. King (Contact Author)

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