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Inflation and Reputation

Author

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  • David Backus
  • John Driffill

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.

Suggested Citation

  • David Backus & John Driffill, 1984. "Inflation and Reputation," Working Paper 560, Economics Department, Queen's University.
  • Handle: RePEc:qed:wpaper:560
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    1. James W. Friedman, 1971. "A Non-cooperative Equilibrium for Supergames," Review of Economic Studies, Oxford University Press, vol. 38(1), pages 1-12.
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    6. Howitt, Peter, 1982. "Anti-inflation policy with a skeptical public : A comment on The Meyer-Webster paper," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 17(1), pages 109-113, January.
    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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