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Discretionary monetary policy and inflation persistence

  • Westelius, Niklas J.

Rational expectations models of staggered price/wage contracts have failed to replicate the observed persistence in inflation and unemployment during disinflation periods. The current literature on this persistency puzzle has focused on augmenting the nominal contract model with imperfect credibility and learning. In this paper, I re-examine the persistency puzzle by focusing on the discretionary nature of monetary policy. I show that when the central bank is allowed to re-optimize a quadratic loss function each period, imperfect credibility and learning, even in the absence of staggered contracts, can generate a significant amount of inflation persistence and employment losses during a disinflationary period.

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Article provided by Elsevier in its journal Journal of Monetary Economics.

Volume (Year): 52 (2005)
Issue (Month): 2 (March)
Pages: 477-496

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Handle: RePEc:eee:moneco:v:52:y:2005:i:2:p:477-496
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505566

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  1. Barro, Robert J & Gordon, David B, 1983. "A Positive Theory of Monetary Policy in a Natural Rate Model," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 589-610, August.
  2. Christopher J. Erceg & Andrew T. Levin, 2001. "Imperfect credibility and inflation persistence," Finance and Economics Discussion Series 2001-45, Board of Governors of the Federal Reserve System (U.S.).
  3. Taylor, John B., 1999. "Staggered price and wage setting in macroeconomics," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 15, pages 1009-1050 Elsevier.
  4. Mark Gertler & Jordi Gali & Richard Clarida, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December.
  5. Laurence Ball, 1992. "Disinflation With Imperfect Credibility," NBER Working Papers 3983, National Bureau of Economic Research, Inc.
  6. Chan G. Huh & Kevin J. Lansing, 1997. "Expectations, credibility, and disinflation in a small macroeconomic model," Working Paper 9713, Federal Reserve Bank of Cleveland.
  7. Jeff Fuhrer & George Moore, 1993. "Inflation persistence," Finance and Economics Discussion Series 93-17, Board of Governors of the Federal Reserve System (U.S.).
  8. Laurence Ball, 1993. "What Determines the Sacrifice Ratio?," NBER Working Papers 4306, National Bureau of Economic Research, Inc.
  9. Peter N. Ireland, 1998. "Does the Time-Consistency Problem Explain the Behavior of Inflation in the United States?," Boston College Working Papers in Economics 415, Boston College Department of Economics.
  10. Ball, Laurence, 1994. "Credible Disinflation with Staggered Price-Setting," American Economic Review, American Economic Association, vol. 84(1), pages 282-89, March.
  11. David Andolfatto & Paul Gomme, 1997. "Monetary Policy Regimes and Beliefs," Cahiers de recherche CREFE / CREFE Working Papers 48, CREFE, Université du Québec à Montréal, revised Apr 2001.
  12. Edmund Phelps, 1978. "Disinflation without recession: Adaptive guideposts and monetary policy," Review of World Economics (Weltwirtschaftliches Archiv), Springer, vol. 114(4), pages 783-809, December.
  13. Peter N. Ireland, 1995. "Optimal disinflationary paths," Working Paper 95-01, Federal Reserve Bank of Richmond.
  14. Taylor, John B, 1983. "Union Wage Settlements during a Disinflation," American Economic Review, American Economic Association, vol. 73(5), pages 981-93, December.
  15. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
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