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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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Suggested Citation

  • D. Backus & J. Driffil, 1998. "Inflation and Reputation," Levine's Working Paper Archive 625, David K. Levine.
    • Handle: RePEc:cla:levarc:625
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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.
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    6. William D. Nordhaus, 1975. "The Political Business Cycle," Review of Economic Studies, Oxford University Press, vol. 42(2), pages 169-190.
    7. 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 473-491, June.
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