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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. Jeff Fuhrer & George Moore, 1993. "Inflation persistence," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
  2. Chan G. Huh & Kevin J. Lansing, 1997. "Expectations, credibility, and disinflation in a small macroeconomic model," Working Paper 9713, Federal Reserve Bank of Cleveland.
  3. Laurence Ball, 1990. "Credible Disinflation with Staggered Price Setting," NBER Working Papers 3555, National Bureau of Economic Research, Inc.
  4. 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.
  5. Clarida, R. & Gali, J. & Gertler, M., 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Working Papers 99-13, C.V. Starr Center for Applied Economics, New York University.
  6. Laurence Ball, 1994. "What Determines the Sacrifice Ratio?," NBER Chapters, in: Monetary Policy, pages 155-193 National Bureau of Economic Research, Inc.
  7. Robert J. Barro & David B. Gordon, 1981. "A Positive Theory of Monetary Policy in a Natural-Rate Model," NBER Working Papers 0807, National Bureau of Economic Research, Inc.
  8. David Andolfatto & Paul Gomme, 1997. "Monetary policy regimes and beliefs," Discussion Paper / Institute for Empirical Macroeconomics 118, Federal Reserve Bank of Minneapolis.
  9. 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.
  10. Ireland, Peter N., 1995. "Optimal disinflationary paths," Journal of Economic Dynamics and Control, Elsevier, vol. 19(8), pages 1429-1448, November.
  11. Laurence Ball, 1992. "Disinflation With Imperfect Credibility," NBER Working Papers 3983, National Bureau of Economic Research, Inc.
  12. John B. Taylor, 1982. "Union Wage Settlements During a Disinflation," NBER Working Papers 0985, National Bureau of Economic Research, Inc.
  13. 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.).
  14. 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.
  15. 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.
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