Dynamic Inconsistency and Self-Fulfilling Expectation Equilibrium

1. Dynamic Inconsistency and Self-Fulfilling Expectation Equilibrium Maurice Obstfeld

2. Dynamic inconsistency and currency crises(Barro-Gordon Type) • Government Objective: Expectations-augmented Phillips Curve =the change in the exchange rate(+ or -) =output target =natural output =domestic price setters expectations of based on lagged information =i.i.d., zero-mean shock y* u Assume: Dynamic inconsistency

3. Government can choose after observing u; unlike price setters. Any depreciation ( )has a cost Any appreciation has a cost :c(low u) for appreciation, or c(high u) for depreciation. If u is between low u and high u the fixed rate is Maintained. Given u<low u, or u> high u the government chooses: With an output level:

4. I. Values Policy loss function (Ignoring the fixed cost): 2. Solving for high u and low u:

5. , uniform distribution. Rational expectations of next period , given the price expectation is:

6. 45 degrees Three Equilibria