Optimal State-Dependent Rules, Credibility and the Cost of Disinflation

Working Paper No. 359 Departamento de Economia-PUC-Rio

Posted: 27 Mar 1997  

Marco Bonomo

Insper Institute of Education and Research

Heitor Almeida

University of Illinois at Urbana-Champaign; National Bureau of Economic Research (NBER)

Date Written: September 1996.

Abstract

This paper examines the costs of disinflation and the role of credibility in a model where pricing rules are optimal and individual prices are rigid. Individual nominal rigidity is modeled as resulting from menu costs. The interaction between optimal pricing rules and credibility is essential in the determination of the costs of disinflation. A continued period of high inflation generates an asymmetric distribution of price deviations, with more prices that are substantially lower than their desired levels than prices that are substantially overvalued. When disinflation is not credible, inflationary inertia is engendered by this asymmetry: idiosyncratic shocks trigger more upward than downward adjustments. A perfectly credible disinflation causes an immediate change of pricing rules which, by rendering the price deviations distribution less asymmetric, practically annihilates inflationary inertia. An implication of our model is that stabilization may be successful even when credibility is absent, provided that it is preceded by a mechanism of price alignment. We also develop an analytical framework for analyzing imperfect credibility cases.

JEL Classification: E31, E52

Suggested Citation

Bonomo, Marco and Almeida, Heitor, Optimal State-Dependent Rules, Credibility and the Cost of Disinflation (September 1996.). Working Paper No. 359 Departamento de Economia-PUC-Rio. Available at SSRN: https://ssrn.com/abstract=9525

Marco Bonomo (Contact Author)

Insper Institute of Education and Research ( email )

R Quata 300
Sao Paulo, 04542-030
Brazil

Heitor Almeida

University of Illinois at Urbana-Champaign ( email )

515 East Gregory Drive
4037 BIF
Champaign, IL 61820
United States
217-3332704 (Phone)

HOME PAGE: http://www.business.illinois.edu/FacultyProfile/faculty_profile.aspx?ID=11357

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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