Academic journal article Economic Review (Kansas City, MO)

Coordination of Expectations in the Recent Crisis: Private Actions and Policy Responses

Academic journal article Economic Review (Kansas City, MO)

Coordination of Expectations in the Recent Crisis: Private Actions and Policy Responses

Article excerpt

The financial crisis of the past two years is unprecedented in the postwar United States. In magnitude and breadth, the crisis has resembled the Great Depression. Policymakers have responded by drawing on standard fiscal and monetary policy tools but also, as the crisis worsened, on a range of exceptional policy actions.

Some of the events have made clear the importance of expectations in an economy. The economic choices individuals make are often based on their expectations of what other people will do--in what economists call a "coordination game." In such situations, changes in the beliefs of what others may do can affect the actions of individuals. A key element in such situations is that, as the collective beliefs change and individuals respond to these altered expectations, the outcome in the marketplace can change. In the recent crisis, the coordination of expectations played a key role in areas such as financial markets, the housing market, and the automobile sector.

When the coordination of expectations results in a crisis or a panic, policymakers are the primary group with the ability to alter the expectations of individuals. By using various policy tools, policymakers can lessen the damage from the crisis. Such tools include providing guarantees and changing marketplace incentives, such as interest rates and tax rates.

This article develops a framework to illustrate how the coordination of expectations was instrumental in the recent economic and financial crisis. The framework also helps describe the actions policymakers took to limit the severity of the downturn by coordinating expectations to achieve more positive outcomes. The first section explains the essential elements of the coordination-game framework. The second section discusses several aspects of the U.S. economy that became important events in the crisis due to changing expectations. The third section describes policy actions that can effectively reshape expectations and restore confidence in the economy. The fourth section discusses actions taken by policymakers in response to the events in the current crisis.

I. A FRAMEWORK FOR ANALYSIS

Coordination games highlight the role of expectations in the choices of economic agents, such as households and firms. In this game, the choices of agents are complementary, meaning that agents have an incentive to do what others are doing. These complementarities often generate multiple outcomes of the interaction between agents. Some of these outcomes are better than others, but no single individual, acting alone, can coordinate the choices of all individuals to achieve the best outcome.

This section describes the general framework of a coordination game. The framework then provides a basis for understanding a classic example of coordination games in financial markets: a bank run.

Coordination games

A coordination game is a strategic situation in which an individual's payoff to taking an action depends on the choices of others (Cooper and John; Cooper).1 Such situations are widespread in an economy: firms interacting with other firms, households interacting with one another, and firms and even governments interacting with each other and with individuals.

A simple example can illustrate a coordination game: the choice of which side of the road to drive on. In the absence of government rules, how would a driver decide whether to drive on the right or left side of the road? The driver would likely make that decision based on his or her belief of what other drivers are most likely to do, thus minimizing the risk of an accident.

As in this example, a couple of characteristics distinguish a coordination game from other forms of strategic interaction. First, individuals in a coordination game want to do what others do. That is, in these games the payoff to an action is higher when that action conforms to the expected action of others. …

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