On the Sources of the Inflation Bias and Output Variability

16 Pages Posted: 29 Dec 2005

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Abstract

Why do dynamic inconsistencies in monetary policy exist? In this paper, a traditional model with output inefficiencies is introduced, but monetary policy is allowed to be influenced by the various constituencies in the economy that pressure Congress in turn to pressure the Central Bank to adopt a particular policy stance. This paper shows that in this economy an inflation bias arises because of the lobbying pressures of outsiders. Furthermore, it shows that if lobbying pressures are high enough, an inflation bias cannot be avoided for any finite level of Central Bank independence. It also shows that introducing the realistic feature of lobbying pressures has an impact on the stabilization properties of monetary policy. When a supply shock occurs, the shock is totally absorbed by a non-myopic trade union, which has no lobbying costs. This is independent of any finite degree of conservativeness of the central banker, who has to accept an extreme increase in price instability. It is shown that monetary policy delegation is therefore sub-optimal in achieving price stability compared with labor-market reforms meant to remove monopsonistic elements. However, the same structural policies will induce greater output instability by strengthening the power of conservative central bankers.

Suggested Citation

Piga, Gustavo, On the Sources of the Inflation Bias and Output Variability. Scottish Journal of Political Economy, Vol. 52, No. 4, pp. 607-622, September 2005. Available at SSRN: https://ssrn.com/abstract=857818 or http://dx.doi.org/10.1111/j.1467-9485.2005.00358.x

Gustavo Piga (Contact Author)

University of Rome ( email )

Via di Tor Vergata
Rome, Lazio
Italy

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