Academic journal article Journal of Money, Credit & Banking

Policy Accommodation and Gradual Stabilizations

Academic journal article Journal of Money, Credit & Banking

Policy Accommodation and Gradual Stabilizations

Article excerpt

ALTHOUGH GOVERNMENTS AND THE PUBLIC dislike inflation, it is difficult to reduce it. Moreover, many countries that have succeeded in reducing inflation have done it slowly, despite the authorities' commitment to and the broad public support for an anti-inflationary objective.(1) The central question of this paper, therefore, is why do inflation-averse policymakers opt to stabilize gradually. Instead of aiming at a sharp reduction of inflation, monetary policy partially accommodates inflationary expectations in order to reduce the recessionary costs of disinflation. If everybody expects that inflation will be low, and acts accordingly, the reduction of inflation should be rapid and costless. However, as shown by Phelps (1978) and Taylor (1983) for economies with staggered contracts, stabilization that aims to minimize output losses must be gradual. This paper goes further by focusing on gradual stabilizations as the equilibrium outcome resulting from the interaction between the private sector and the policymaker.

As recently shown by Cukierman and Liviatan (1992), informational frictions may result in an equilibrium where even a policymaker with no inflationary bias will implement a gradual stabilization. The driving force of this model is a credibility problem. The assumption is that there are two types of governments and the public does not know which one is in office. One has no inflationary bias, and is called strong. The other, called weak, would like to create inflationary surprises to achieve a level of output that is above that of full employment.(2) The intuition for the persistence of inflation is that when there is a positive probability that the policymaker is weak, people will have higher inflationary expectations than when they know with certainty that the government is strong. This bias in inflationary expectations induces the strong government to partially accommodate these expectations because it also dislikes recessions.

In this paper I analyze gradual stabilizations without resorting to uncertainty about the preferences of the policymaker. The public and the policymaker both dislike inflation as well as deviations of output from the level of full employment, but the inability to coordinate their actions generates the incentive for policy accommodation. Two monetary policy games, in the tradition of Barro and Gordon (1983), where equilibrium disinflations are gradual, are presented below.

Throughout the paper I focus mainly on the case where a policymaker faces a rate of inflation that is above its optimal value, but how the economy has reached this state is not specified. The initial high rate of inflation may be the result of large negative supply shocks, such as an oil shock or a shortage of external financing. Alternatively, this setup may result from a change in regime, such as the requirement of inflation convergence in countries attempting to participate in the European Monetary Union or undergoing a change of government.

The basic reason why monetary policy is accommodative, and hence disinflation is gradual, is a bias in the public's expectations about inflation. Although it is common knowledge that the government has no incentive to create inflationary surprises, the two models presented below explain why the public may have expectations of inflation being above zero. This expectational bias induces the government to pursue an accommodative policy in order to mitigate the recession associated with disinflation. The first model, developed in section 1, is based on the existence of backward-looking indexation. In this model, past inflation is a determinant of current output, and consequently is incorporated in private agents' expectations about government policy.(3) The other model, discussed in section 2, assumes that there is a fixed cost of implementing a stabilization program. If the public forms expectations before observing the realization of an exogenous real shock, which is observed by the government, there will be an inflationary bias because of the uncertainty about whether or not the government will implement disinflation measures. …

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