A discretionary policy-maker responds to the state of the economy each period. Private agents' current behavior determines the future state based on expectations of future policy. Discretionary policy thus can lead to dynamic complementarity between private agents and a policy-maker, which in turn can generate multiple equilibria. Working in a simple new Keynesian model with two-period staggered pricing—in which equilibrium is unique under commitment—we illustrate this interaction: if firms expect a high future money supply, (i) they will set a high current price; and (ii) the future monetary authority will accommodate with a higher money supply, so as not to distort relative prices. We show that there are two point-in-time equilibria under discretion, and we construct a related stochastic sunspot equilibrium.

Economists have long suggested that nominal product prices are changed infrequently because of fixed costs. In such a setting, optimal price adjustment should depend on the state of the economy. Yet, while widely discussed, statedependent pricing has proved difficult to incorporate into macroeconomic models. This paper develops a new, tractable theoretical state-dependent pricing framework. We use it to study how optimal pricing depends on the persistence of monetary shocks, the elasticities of labor supply and goods demand, and the interest sensitivity of money demand.