Coordination and Policy Traps

This paper examines the ability of a policy maker to fashion equilibrium outcomes in an environment where market participants play a coordination game with heterogeneous information. We consider a simple model of regime change that embeds many applications examined in the literature. In equilibrium, the policy maker is willing to take a costly policy action only for moderate fundamentals. Market participants can use this information to coordinate on different responses to the same policy choice, thus inducing policy traps, where the optimal policy and the resulting regime outcome are dictated by self-fulfilling market expectations. Despite equilibrium multiplicity, robust predictions can be made. The probability of regime change is monotonic in the fundamentals, the policy maker intervenes only in a region of intermediate fundamentals, and this region shrinks as the information in the market becomes precise