Because inflation exhibits a high degree of persistence, once it rises, it is likely to remain high for some time. The early literature on rational expectations demonstrates that persistent inflation arises whenever governments adopt accommodative monetary policies. Carrying this premise one step further, the paper examines a framework in which the government and the public dislike inflation as well as deviations of output from full employment, but their inability to coordinate their actions generates the incentive for accommodation. The paper highlights elements of the economic and informational structure that may induce governments to adopt accommodative policies, using as examples three different cases where monetary policy ends up being accommodative.
The paper uses as its basic model a monetary policy game, whose analysis it extends to models that predict persistent inflation rates and gradual stabilization. The underlying reason for accommodation is a bias in people’s expectations about inflation. Although the government has no inflationary bias, the three models show that people have inflation expectations above zero. This expectational bias induces the government to accommodate in order to avoid the severe recessions associated with inflation that is lower than expected.
The models presented in the paper provide different explanations for the upward bias in inflation expectations. The first points to indexation as the principal reason for government to accommodate inflation expectations rather than to reduce inflation over a short period. The second model, a simplified version of a model developed by Cukierman and Liviatan (1990), focuses on how uncertainty as to a policymaker’s preferences leads to accommodative policies. The last model considers a policymaker who faces a fixed cost each time he decides to reduce inflation. Public uncertainty as to whether the current economic conditions are such that the policymaker will bear the fixed cost results in inflation persistence. The paper also presents some cross-country evidence on inflation persistence in a sample of 29 countries during 1970-90.