Bayes correlated equilibrium and inflationary bias
v) The role of credibility and signal transmissions – echoing the theoretical framework proposed by Barro & Gordon 1983, our model bases the credibility of the CB on efficient signalling/communicative strategies. Specifically, the transmission of clear, consistent signals is vital for influencing market dynamics and controlling agents ’ behaviours. vi) Iterative policy evolution and economic learning – our model recognize s the CB’s iterative recalibration of strategies in light of feedback mechanisms. A persistent focus on macroeconomic stability informs the spectrum of policy adaptation, aligning with the dynamic stochastic general equilibrium (DSGE) models suggested by Clarida et al. 1999.
Modelling of inflation bias in CB policy
The objective is to create a robust model that demonstrates how CB policies can inadvertently instigate and preserve a cycle of high inflation, in particular through asymmetric policy preferences and cautious unemployment targeting. The analysis begins with the model devised by (Ruge-Murcia 2004), which explores the impact of unemployment targeting on inflation. The model is expressed as where 𝜋 represents inflation, 𝑢 actual unemployment, 𝑢 the targeted natural rate, 𝑔 other government policy measures, and 𝜖 an error term. 𝜃 is crucial here as it quantifies the sensitivity of inflation to deviations from the natural rate of unemployment. A high positive 𝜃 indicates that high unemployment rates could prompt the CB to implement policies that inadvertently lead to higher inflation, thereby entrenching an inflation bias into the economy. 1
Building on (1) , the model extends to include (Ruge-Murcia 2003):
where 𝜋 is the target inflation, 𝑦 output relative to potential output 𝑦 , and 𝑧 captures external shocks. The parameter 𝑘 measures the CB’s sensitivity to deviations from target inflation, reflecting there is a greater persistence of inflation bias when 𝜅 is low, i.e. less aggressive response to deviations. 2
To link past outcome inflation outcomes with current policy, a dynamic feedback mechanism based on adaptive expectations and past policy outcomes is introduced. This is given by
where 𝐸 ( 𝜋 ) represents the expected future inflation, 𝑥 additional macroeconomic indicators, and ∆ 𝑢 the change in unemployment. This formulation allows the analysis of how past inflation, modified by policy adjustments, influences expected future inflation, thereby creating a potential cycle of self- reinforcing high inflation if expectations are not managed effectively. 3
1 The parameter 𝜃 accounts for the influence of other government policies on inflation, suggesting an interaction between monetary and fiscal measures that is often overlooked in simpler models. 2 In addition, the inclusion of 𝜆 and 𝜏 demonstrates the model’s capacity to include both output and external shocks, providing a more thorough view of the environment influencing policy decisions. 3 The adaptive mechanism ( 𝑎 1 , 𝑎 2 , 𝑎 3 ) emphasizes the importance of past inflation, economic conditions, and unemployment changes in forming future inflation expectations. This reflects the iterative nature of monetary policy impacts.
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