Learning, Endogenous Indexation and Disinflation in the New-Keynesian Model

35 Pages Posted: 10 Jun 2008  

Volker Wieland

University of Frankfurt

Multiple version iconThere are 2 versions of this paper

Date Written: March 1, 2008

Abstract

This paper introduces adaptive learning and endogenous indexation in the New-Keynesian Phillips curve and studies disinflation under inflation targeting policies. The analysis is motivated by the disinflation performance of many inflation-targeting countries, in particular the gradual Chilean disinflation with temporary annual targets. At the start of the disinflation episode price-setting firms' expect inflation to be highly persistent and opt for backward-looking indexation. As the central bank acts to bring inflation under control, price-setting firms revise their estimates of the degree of persistence. Such adaptive learning lowers the cost of disinflation. This reduction can be exploited by a gradual approach to disinflation. Firms that choose the rate for indexation also re-assess the likelihood that announced inflation targets determine steady-state inflation and adjust indexation of contracts accordingly. A strategy of announcing and pursuing short-term targets for inflation is found to influence the likelihood that firms switch from backward-looking indexation to the central bank's targets. As firms abandon backward-looking indexation the costs of disinflation decline further. We show that an inflation targeting strategy that employs temporary targets can benefit from lower disinflation costs due to the reduction in backward-looking indexation.

Keywords: disinflation, indexation, inflation targeting, learning, monetary policy, New-Keynesian model, recursive least squares

JEL Classification: E32, E41, E43, E52, E58

Suggested Citation

Wieland, Volker, Learning, Endogenous Indexation and Disinflation in the New-Keynesian Model (March 1, 2008). , Vol. , pp. -, 2008. Available at SSRN: https://ssrn.com/abstract=1141654

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