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

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