Working Paper: NBER ID: w31207
Authors: Hassan Afrouzi; Marina Halac; Kenneth S. Rogoff; Pierre Yared
Abstract: This paper studies the implications of central bank credibility for long-run inflation and inflation dynamics. We introduce central bank lack of commitment into a standard non-linear New Keynesian economy with sticky-price monopolistically competitive firms. Inflation is driven by the interaction of lack of commitment and the economic environment. We show that long-run inflation increases following an unanticipated permanent increase in the labor wedge or decrease in the elasticity of substitution across varieties. In the transition, inflation overshoots and then gradually declines. Quantitatively, the inflation response is large, as is the welfare loss from lack of commitment relative to inflation targeting.
Keywords: central bank credibility; inflation dynamics; New Keynesian model
JEL Codes: D02; E02; E52; E58; E61
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Labor wedge increase (J39) | Long-run inflation increase (E31) |
| Elasticity of substitution decrease (D11) | Long-run inflation increase (E31) |
| Central bank lack of commitment (E58) | Interest rates cut (E43) |
| Interest rates cut (E43) | Inflation expectations increase (E31) |
| Inflation overshooting (E31) | Higher inflation before stabilization (E31) |
| Price dispersion increase (D49) | Inflation overshooting (E31) |
| Labor misallocation increase (J29) | Inflation overshooting (E31) |