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.
Our Research Focus: Inflation and Monetary Policy
Amanda L. Kramer
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