Working Paper: CEPR ID: DP159
Authors: John Driffill
Abstract: In several recent papers macroeconomic policy has been modelled in the context of a game of incomplete information. A central result of the work by Backus and Driffill and by Barro is that the uncertainty may provide an incentive for the government to maintain a socially efficient policy of zero inflation for most of the game, without any formal precommitment, thereby avoiding the inflationary bias which would be associated with discretionary policy. This paper extends this analysis in two ways. First, it considers a model in which the uncertainty about the government's preferences is somewhat more broadly specified. Second, it considers a model in which some exogenous random shocks impinge on the economy and not only prevent the government from exercising perfect control but also prevent the private sector of the economy from observing exactly the policy measures taken by the government. The analysis of the more general model of uncertainty about preferences supports the results of Backus and Driffill and of Barro, in that the uncertainty induces low or zero inflation outcomes in the sequential equilibrium of the game. It also reconciles their results with those of Vickers who obtained a separating rather than a pooling equilibrium from a model with a very similar structure. The analysis of the model with random shocks indicates tentatively that the signal extraction problem faced by private sector agents as a result of the shocks reduces substantially the discipline on policy-makers which reputational considerations would otherwise impose.
Keywords: macroeconomic policy; sequential equilibrium; time inconsistency; inflationary bias
JEL Codes: 023; 026; 134; 311
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Uncertainty about government preferences (D89) | low or zero inflation outcomes (E31) |
| Private sector's perception of government commitment (H11) | actual inflation rates (E31) |
| Government's reputation (H11) | private sector's beliefs based on observed inflation outcomes (E31) |
| Random shocks (E32) | discipline imposed on policymakers by reputational considerations (D73) |
| Uncertainty about government preferences (D89) | behavior similar to committed government (H11) |