Using a Projection Method to Analyze Inflation Bias in a Micro-Founded Model

Abstract

Since Kydland and Prescott (1977) and Barro and Gordon (1983), most studies of the problem of the inflation bias associated with discretionary monetary policy have assumed a quadratic loss function. We depart from the conventional linear-quadratic approach to the problem in favor of a projection method approach. We investigate the size of the inflation bias that arises in a microfounded nonlinear environment with Calvo price setting. The inflation bias is found to lie between 1% and 6% for a reasonable range of parameter values, when the bias is defined as the steady-state deviation of the discretionary inflation rate from the optimal inflation rate under commitment.

Keywords: Inflation bias, discretionary monetary policy, projection methods

JEL Classification: E31, E52, C61, C63