Working Paper: CEPR ID: DP702
Authors: Ali Ainowaihi; Paul Levine
Abstract: This paper provides a resolution of the non-uniqueness of reputational equilibria in the Barro-Gordon monetary policy game. We introduce a `chisel-proof' credibility condition which ensures that in response to a small deviation from the low inflation rate by the central bank, it never pays for the private sector to acquiesce. This condition, which amounts to a refinement of the subgame perfect equilibrium, endogenizes the punishment length of the private sector's trigger strategy. The result is that a unique low-inflation outcome can be enforced as a sub-game perfect and credible non-cooperative equilibrium. A combination of discount factors close to unity for both players and short-wage contracts is the desirable combination to drive the best enforceable inflation outcome towards the ideal zero rate.
Keywords: monetary policy; reputational equilibria; multiple equilibria; credibility
JEL Codes: E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| chiselproof credibility condition (D81) | unique low-inflation outcome (E31) |
| central bank's inflation rate (E52) | private sector's expectations of inflation (E31) |
| private sector's expectations of inflation (E31) | central bank's inflation rate (E52) |
| size of deviation from low inflation (E31) | punishment length for deviations (K40) |
| punishment length for deviations (K40) | credible noncooperative equilibrium (C72) |
| discount factors close to unity + short-wage contracts (J41) | best enforceable inflation outcome (E64) |
| magnitude of deviation (C20) | punishment fitting the crime (K42) |