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Central bank credibility and the persistence of inflation and inflation expectations

  • J. Scott Davis

This paper introduces a model where agents are unsure about the central bank's inflation target. They believe that the central bank's inflation target could lie between two extremes, and their beliefs vary depending on the central bank's stock of credibility. They form the expectations used in price and wage setting using this perceived inflation target, and they use past observations of inflation to update their beliefs about the credibility of the central bank. Thus a series of high inflation observations can lead them to believe (incorrectly) that the central bank has adopted a high target. High inflation expectations are incorporated into price and wage setting decisions, and a transitory shock to inflation can become very persistent. The model with endogenous credibility can match the volatility and persistence of both inflation and measures of long-term inflation expectations that we see in the data. The model is then calibrated to match the observed levels of Federal Reserve credibility in the 1980s and the 2000s. By simply changing the level of credibility, holding all else fixed, the model can explain nearly all of the observed changes in the volatility and persistence of inflation and inflation expectations in the U.S. from the 1980s to today.

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File URL: http://www.dallasfed.org/assets/documents/institute/wpapers/2012/0117.pdf
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Paper provided by Federal Reserve Bank of Dallas in its series Globalization and Monetary Policy Institute Working Paper with number 117.

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Date of creation: 2012
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Handle: RePEc:fip:feddgw:117
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  1. Leduc, Sylvain & Sill, Keith & Stark, Tom, 2007. "Self-fulfilling expectations and the inflation of the 1970s: Evidence from the Livingston Survey," Journal of Monetary Economics, Elsevier, vol. 54(2), pages 433-459, March.
  2. Blanchard, Olivier J & Galí, Jordi, 2008. "The Macroeconomic Effects of Oil Shocks: Why are the 2000s so Different from the 1970s?," CEPR Discussion Papers 6631, C.E.P.R. Discussion Papers.
  3. 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.
  4. Todd E. Clark & Troy Davig, 2009. "Decomposing the declining volatility of long-term inflation expectations," Research Working Paper RWP 09-05, Federal Reserve Bank of Kansas City.
  5. Joseph Haubrich & George Pennacchi & Peter Ritchken, 2012. "Inflation Expectations, Real Rates, and Risk Premia: Evidence from Inflation Swaps," Review of Financial Studies, Society for Financial Studies, vol. 25(5), pages 1588-1629.
  6. Refet S. Gürkaynak & Andrew T. Levin & Eric T. Swanson, 2006. "Does inflation targeting anchor long-run inflation expectations? evidence from long-term bond yields in the U.S., U.K., and Sweden," Working Paper Series 2006-09, Federal Reserve Bank of San Francisco.
  7. David Andolfatto & Scott Hendry & Kevin Moran, 2005. "Are Inflation Expectations Rational?," Macroeconomics 0501002, EconWPA.
  8. Olivier Blanchard & Marianna Riggi, 2011. "Why are the 2000s so different from the 1970s? A structural interpretation of changes in the macroeconomic effects of oil prices in the US," Temi di discussione (Economic working papers) 835, Bank of Italy, Economic Research and International Relations Area.
  9. Yash P. Mehra & Christopher Herrington, 2008. "On the sources of movements in inflation expectations : a few insights from a VAR model," Economic Quarterly, Federal Reserve Bank of Richmond, issue Spr, pages 121-146.
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