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The inflation bias revisited: theory and some international evidence

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  • Alex Cukierman
  • Stefan Gerlach

Abstract

The Kydland-Prescott, Barro-Gordon inflation bias result relies on the presumption that policymakers aim at achieving a level of employment above potential. Both academics and policymakers have recently questioned this presumption on the ground of realism. We show that even if policymakers are content with the normal level of employment there is an inflation bias if the central bank is uncertain about the future state of the economy, and is more sensitive to policy misses leading to employment below the normal level than to policy misses leading to employment above it. This new view of the inflation bias implies that there should be a positive association between average inflation and the variance of shocks to output. Cross sectional empirical evidence from 21 developed economies supports this implication. The Paper also discusses the consequences for the transparency of monetary policy and for central bank reform.

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Bibliographic Info

Article provided by University of Manchester in its journal The Manchester School.

Volume (Year): 71 (2003)
Issue (Month): 5 (09)
Pages: 541-565

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Handle: RePEc:bla:manchs:v:71:y:2003:i:5:p:541-565

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References

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  1. Lars E O Svensson, 1996. "Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets," Bank of England working papers, Bank of England 56, Bank of England.
  2. Richard H. Clarida & Mark Gertler, 1997. "How the Bundesbank Conducts Monetary Policy," NBER Chapters, in: Reducing Inflation: Motivation and Strategy, pages 363-412 National Bureau of Economic Research, Inc.
  3. Richard Clarida & Jordi Galí & Mark Gertler, 2000. "Monetary Policy Rules And Macroeconomic Stability: Evidence And Some Theory," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 115(1), pages 147-180, February.
  4. Fischer, Stanley, 1977. "Long-Term Contracts, Rational Expectations, and the Optimal Money Supply Rule," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 85(1), pages 191-205, February.
  5. Persson, Torsten & Tabellini, Guido, 1997. "Political Economics and Macroeconomic Policy," CEPR Discussion Papers, C.E.P.R. Discussion Papers 1759, C.E.P.R. Discussion Papers.
  6. Alex Cukierman & V. Anton Muscatelli, 2002. "Do Central Banks have Precautionary Demands for Expansions and for Price Stability? - Theory and Evidence," CESifo Working Paper Series 764, CESifo Group Munich.
  7. Lars E.O. Svensson, 1995. "Optimal Inflation Targets, `Conservative' Central Banks, and Linear Inflation Contracts," NBER Working Papers 5251, National Bureau of Economic Research, Inc.
  8. Alex Cukierman, 2002. "Are contemporary central banks transparent about economic models and objectives and what difference does it make?," Review, Federal Reserve Bank of St. Louis, Federal Reserve Bank of St. Louis, issue Jul, pages 15-36.
  9. Alan S. Blinder, 1999. "Central Banking in Theory and Practice," MIT Press Books, The MIT Press, The MIT Press, edition 1, volume 1, number 0262522608, December.
  10. Rogoff, Kenneth, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 100(4), pages 1169-89, November.
  11. Lohmann, Susanne, 1992. "Optimal Commitment in Monetary Policy: Credibility versus Flexibility," American Economic Review, American Economic Association, American Economic Association, vol. 82(1), pages 273-86, March.
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  13. Douglas O. Staiger & James H. Stock & Mark W. Watson, 1997. "How Precise Are Estimates of the Natural Rate of Unemployment?," NBER Chapters, in: Reducing Inflation: Motivation and Strategy, pages 195-246 National Bureau of Economic Research, Inc.
  14. Guy Debelle & Stanley Fischer, 1994. "How independent should a central bank be?," Conference Series ; [Proceedings], Federal Reserve Bank of Boston, Federal Reserve Bank of Boston, vol. 38, pages 195-225.
  15. Alex Cukierman & Anton Muscatelli, 2001. "Do Central Banks have Precautionary Demands for Expansions and for Price Stability?," Working Papers, Business School - Economics, University of Glasgow 2002_4, Business School - Economics, University of Glasgow, revised Mar 2002.
  16. Cukierman, A., 1996. "The Economics of Central Banking," Discussion Paper, Tilburg University, Center for Economic Research 1996-31, Tilburg University, Center for Economic Research.
  17. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 85(3), pages 473-91, June.
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  19. Ruge-Murcia, Francisco J., 2004. "The inflation bias when the central bank targets the natural rate of unemployment," European Economic Review, Elsevier, Elsevier, vol. 48(1), pages 91-107, February.
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  21. Vickers, John, 1986. "Signalling in a Model of Monetary Policy with Incomplete Information," Oxford Economic Papers, Oxford University Press, vol. 38(3), pages 443-55, November.
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