Bayes correlated equilibrium and inflationary bias
Combining these models provides a holistic view of the inflation process under CB policies. We express this as
incorporating expectations, unemployment targeting, output effects, and external shocks, all compounded by 𝜉 t , a refined error term for unmodelled influences. (4) stresses the heterogeneous impact of CB policies, including direct effects on inflation and indirect effects through expectations and real activity. Overall, the chain of analysis above provides insight into how CB policies, specifically those focusing on unemployment targets or exhibiting asymmetry in inflation responses, can entrench an economy in a cycle of persistently high inflation. The model also emphasizes the importance of balanced policy measures that consider the broader implications of targeting specific metrics such as the natural rate of unemployment, a critical approach for crafting policies that may limit rather than exacerbate this inflationary bias.
Literature solutions
A solution came from Rogoff (Canzoneri 1985) who asserted that authorities in the C. could have a different utility function from the rest of society, specifically one less tolerant of inflation. He believed this would help improve the outcome of the non-cooperative game. The problem with this proposal was that it produced inflation rates that were too stable in comparison with the actual empirical evidence, (see Canzoneri 1985). In a bid to resolve this problem, Rogoff transformed his game into that of a Bayesian context, where there were different types of policymakers, each claiming to be a crusader of anti-inflation. However, his exploration of the entire spectrum between absolute commitment and complete lack of commitment, in search for pareto improvement, has proven unfruitful. An alternative suggestion came from Albanesi et al. 2003, who transformed the time inconsistency problems into a general equilibrium context to demonstrate that expectation traps, arising from defensive actions by economic agents and strategic responses by monetary authorities, stabilize undesirable inflation outcomes through pre-emptive pricing and spending behaviours influenced by anticipated inflation levels. The model employs a Markov perfect equilibrium framework to prove that optimal (current) policy actions are those based on the present economic conditions (i.e. objectives and data) instead of past states and that this reliance on present information limits the inflationary bias arising from time inconsistency. 4 However, this model faces extensive practical challenges: i. Equilibrium indeterminacy – the potential for multiple equilibria 5 to exist adds further complexity to the policy implementation process as it requires the CB assess which actions achieve a desirable equilibrium without destabilizing the economic environment.
4 In addition, by continuously updating policy based on the evolving state of the economy, the risk of outdated responses is minimized, ensuring that inflation targets are maintained more consistently even as external economic variables shift. 5 Each equilibrium represents a different configuration of economic outcomes, including inflation levels, employment, or growth.
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