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Inflation and Reputation

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  • D. Backus
  • J. Driffil

Abstract

In many macroeconomic models with rational expectations, optimal policy is time inconsistent, and therefore announced policy may not be credible. This paper models the government's credibility explicitly, using Kreps and Wilson's analysis. Time-consistent optimal government policy emerges as a sequential equilibrium in a repeated game. This policy is at least as good as the inconsistent 'optimal' policy, and dominates the consistent policy when reputational effects are ignored. Thus, the analysis resolves the problem of specifying a credible optimal policy in such models. The results show why attempts to disinflate may lead to recession, even with perfectly flexible prices.

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Bibliographic Info

Paper provided by David K. Levine in its series Levine's Working Paper Archive with number 625.

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Date of creation: 15 Apr 1998
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Handle: RePEc:cla:levarc:625

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Web page: http://www.dklevine.com/

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  1. Chappell, Henry W, Jr, 1983. "Presidential Popularity and Macroeconomic Performance: Are Voters Really So Naive?," The Review of Economics and Statistics, MIT Press, vol. 65(3), pages 385-92, August.
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