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Escaping Nash and volatile inflation

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  • Martin Ellison
  • Tony Yates

Abstract

Why is inflation so much lower and at the same time more stable in developed economies in the 1990s, compared with the 1970s? This paper suggests that the United Kingdom, United States and other countries may have escaped from a volatile inflation equilibrium. Our argument builds on the story proposed by Tom Sargent in The conquest of American inflation, where the fall in inflation in the 1980s was attributed to the changing beliefs informing monetary policy. To explain the escape in inflation volatility, we unwind one of Sargent’s simplifications and allow the monetary authority to react to some of the shocks in the economy. In this new model, a revised account of recent history is that when the evidence turned against the existence of a long-run inflation-output trade-off in the 1980s there was an escape from high inflation, but the authorities were also persuaded to stop using changes in inflation to offset shocks. Inflation and inflation volatility therefore escaped in tandem. Our analysis also sheds some light on why the escape in inflation occurred at the time it did. Our model, like the Sargent model it derives from, omits the revolution in institutional design and understanding that underpins monetary policy. So the gloomy predictions for the future derived from a literal reading of it are likely to be unfounded.

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Paper provided by Bank of England in its series Bank of England working papers with number 330.

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Date of creation: Jul 2007
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Handle: RePEc:boe:boeewp:330

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  1. Giorgio Primiceri, 2005. "Why Inflation Rose and Fell: Policymakers' Beliefs and US Postwar Stabilization Policy," NBER Working Papers 11147, National Bureau of Economic Research, Inc.
  2. Bruce McGough, 2003. "Shocking Escapes," Computing in Economics and Finance 2003, Society for Computational Economics 294, Society for Computational Economics.
  3. Timothy Cogley & Riccardo Colacito & Thomas J. Sargent, 2007. "Benefits from U.S. Monetary Policy Experimentation in the Days of Samuelson and Solow and Lucas," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 39(s1), pages 67-99, 02.
  4. Giordani, Paolo & Soderlind, Paul, 2003. "Inflation forecast uncertainty," European Economic Review, Elsevier, Elsevier, vol. 47(6), pages 1037-1059, December.
  5. Phelps, Edmund S & Taylor, John B, 1977. "Stabilizing Powers of Monetary Policy under Rational Expectations," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 85(1), pages 163-90, February.
  6. Timothy Cogley & Thomas J. Sargent, 2005. "The conquest of US inflation: Learning and robustness to model uncertainty," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 8(2), pages 528-563, April.
  7. William Poole, 2002. "Flation," Speech, Federal Reserve Bank of St. Louis 49, Federal Reserve Bank of St. Louis.
  8. Cho, In-Koo & Williams, Noah & Sargent, Thomas J, 2002. "Escaping Nash Inflation," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 69(1), pages 1-40, January.
  9. Reis Ricardo, 2003. "Where Is the Natural Rate? Rational Policy Mistakes and Persistent Deviations of Inflation from Target," The B.E. Journal of Macroeconomics, De Gruyter, De Gruyter, vol. 3(1), pages 1-40, September.
  10. Andrea Gerali & Francesco Lippi, 2002. "On the 'conquest' of inflation," Temi di discussione (Economic working papers), Bank of Italy, Economic Research and International Relations Area 444, Bank of Italy, Economic Research and International Relations Area.
  11. Orphanides, Athanasios, 2000. "The quest for prosperity without inflation," Working Paper Series, European Central Bank 0015, European Central Bank.
  12. El-Gamal, Mahmoud A. & Sundaram, Rangarajan K., 1993. "Bayesian economists ... Bayesian agents : An alternative approach to optimal learning," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 17(3), pages 355-383, May.
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Cited by:
  1. George W. Evans & Seppo Honkapohja, 2009. "Expectations, Learning and Monetary Policy: An Overview of Recent Research," Central Banking, Analysis, and Economic Policies Book Series, Central Bank of Chile, in: Klaus Schmidt-Hebbel & Carl E. Walsh & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Series (ed.), Monetary Policy under Uncertainty and Learning, edition 1, volume 13, chapter 2, pages 027-076 Central Bank of Chile.
  2. Mitra, Kaushik & Evans, George W. & Honkapohja, Seppo, 2013. "Policy change and learning in the RBC model," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 37(10), pages 1947-1971.
  3. Dmitri Kolyuzhnov & Anna Bogomolova & Sergey Slobodyan, 2006. "Escape Dynamics: A Continuous—Time Approximation," CERGE-EI Working Papers wp285, The Center for Economic Research and Graduate Education - Economic Institute, Prague.
  4. Rhys Bidder & Kalin Nikolov & Tony Yates, . " Self-confirming Inflation Persistence," CDMA Conference Paper Series, Centre for Dynamic Macroeconomic Analysis 0908, Centre for Dynamic Macroeconomic Analysis.
  5. Evans, George & Honkapohja, Seppo, 2008. "Expectations, Learning and Monetary Policy: An Overview of Recent Research," SIRE Discussion Papers, Scottish Institute for Research in Economics (SIRE) 2008-03, Scottish Institute for Research in Economics (SIRE).

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