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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. Peter N. Ireland, 1995. "Optimal disinflationary paths," Working Paper 95-01, Federal Reserve Bank of Richmond.
  2. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," CEPR Discussion Papers 2139, C.E.P.R. Discussion Papers.
  3. Laurence Ball, 1992. "Disinflation With Imperfect Credibility," NBER Working Papers 3983, National Bureau of Economic Research, Inc.
  4. David Andolfatto & Paul Gomme, 2003. "Monetary Policy Regimes and Beliefs," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 44(1), pages 1-30, February.
  5. 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.).
  6. John B. Taylor, 1998. "Staggered Price and Wage Setting in Macroeconomics," NBER Working Papers 6754, National Bureau of Economic Research, Inc.
  7. Laurence Ball, 1994. "What Determines the Sacrifice Ratio?," NBER Chapters, in: Monetary Policy, pages 155-193 National Bureau of Economic Research, Inc.
  8. Huh, Chan G. & Lansing, Kevin J., 2000. "Expectations, credibility, and disinflation in a small macroeconomic model," Journal of Economics and Business, Elsevier, vol. 52(1-2), pages 51-86.
  9. Edmund Phelps, 1978. "Disinflation without recession: Adaptive guideposts and monetary policy," Review of World Economics (Weltwirtschaftliches Archiv), Springer;Institut für Weltwirtschaft (Kiel Institute for the World Economy), vol. 114(4), pages 783-809, December.
  10. Taylor, John B, 1983. "Union Wage Settlements during a Disinflation," American Economic Review, American Economic Association, vol. 73(5), pages 981-93, December.
  11. 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.
  12. Jeff Fuhrer & George Moore, 1995. "Inflation Persistence," The Quarterly Journal of Economics, Oxford University Press, vol. 110(1), pages 127-159.
  13. Ball, Laurence, 1994. "Credible Disinflation with Staggered Price-Setting," American Economic Review, American Economic Association, vol. 84(1), pages 282-89, March.
  14. 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.
  15. Ireland, Peter N., 1999. "Does the time-consistency problem explain the behavior of inflation in the United States?," Journal of Monetary Economics, Elsevier, vol. 44(2), pages 279-291, October.
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