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The authors are grateful to Ernesto Hernández-Catá for encouraging them to work in this area, to Joseph Gagnon and Ralph for discussions of the issues, and to Charles Adams, David Coe. Steven Symansky, and seminar participants at the Reserve Bank of Australia for their comments on drafts of the paper.
The goal of price stability was the focus of the policy discussion in Chapter II of the May 1990 issue of the World Economic Outlook (Washington: International Monetary Fund), which presents analysis based on a preliminary version of this paper.
Commission of the European Communities, "Draft Treaty Amending the Treaty Establishing the European Economic Community with a View to Achieving Economic and Monetary Union," Brussels, December 1990. EC Commission (1990) discusses the goal of price stability in a European context.
We will not consider here the costs of inflation; see for instance, Chapters 1-4 of Fischer (1986).
This point is made strongly by Ball (1991), who shows that a reasonably rapid credible disinflation could cause a boom in output, not output losses in a model with sticky prices (a possibility earlier raised by Fischer (1986, p. 252)).
For a comparison of alternative macro-econometric models see Bryant, Henderson, Holtham, Hooper, and Symansky (1988). Obstfeld and Rogoff (1984) show how frequently used alternative price adjustment rules can alter even the qualitative response of the economy to the same shock.
This is not to imply that expectational errors cannot occur in these models, in that there are unanticipated shocks to the economy. The point is rather that agents do not systematically and continuously make mistakes in the same direction, as would occur, for example, in a model with adaptive expectations when the rate of inflation permanently increases.
There is no presumption in this approach that formal contracts are written. Only that nominal prices (wages) are pre-set for some period of time.
Again, we do not distinguish between wages and prices since this literature typically assumes that prices are a constant mark-up over wage costs.
For the price quotation or ‘contract’ to be binding it is necessary to make additional assumptions since in a stochastic environment such contracts will typically be time inconsistent. An alternative approach is adopted by Barro (1972) and Sheshinski and Weiss (1983) who allow the ‘contract’ to be renegotiated when the benefits of such a renegotiation outweigh the costs. The optimal policy is an (S, s) policy, that is the price is changed when it deviates by more than a critical magnitude from the optimal or equilibrium flexible price. Parkin (1986) examines the optimality of alternative wage staggering rules.
And perhaps also a term representing the change in excess demand, due to a variable mark-up of prices over unit costs.
This model extends the model of the previous section because it makes money demand explicit and models the transmission of monetary policy through the channel of interest rates. For simplicity, we ignore the effect of trend growth in capacity output on money demand, and assume that equilibrium real interest rates are zero. These simplifications could be relaxed without changing the analysis.
If δ < 0.5, then zero output losses would require ever-accelerating declines in inflation, which, however, must eventually come to a halt to prevent ΔPt becoming unbounded in a downward direction. At this point (if not before) output losses would be incurred.
The first difference of capacity utilization did not enter significantly, so is ignored in what follows.
Instrumental variables were used in estimation to control for the endogeneity of the other regressors, as discussed below.
The capacity utilization rate was constructed using a time-series filter to derive a capacity output series for each G-7 country from observed quarterly GNP data. The filter is the variant of the one developed by Hodrick and Prescott (1980), which has been used extensively to detrend economic data for the analysis of real business cycles (see, e.g., Backus and others (1989)).
The problem with the U.K. data is associated with the surge in inflation from 7 percent in 1973 to over 27 percent in 1975, and the sharp decline thereafter. This surge of inflation was not related to strong economic activity—1975 was a recession year in the U.K.—but rather seems to reflect a wage-price spiral caused by attempts to recover real wage losses following the first oil price shock.
The (country-specific) constant terms were all small and insignificant in preliminary estimation: they have been constrained to zero. Estimation was also performed allowing for first-order autoregressive and moving average processes for the residuals: these coefficients were insignificant as a group and had little effect on the other parameter values, thus they were excluded in further estimation. It should be noted that the estimate of the asymptotic variance-covariance matrix of the parameters used to construct the t-ratios may not be consistent for the reasons discussed in Cumby and others (1983).
The test statistic is asymptotically distributed X2(n), where n is the number of linear constraints. It will not necessarily be positive in finite samples, as the estimates of the variance-covariance matrix of the residuals in the restricted and unrestricted models are not identical.
This can be seen by calculating d2f(CU)/dCU2 = a42/(a4-(CU/100-1))3. It is apparent that this expression—which indicates the change in the slope of the output-price tradeoff as CU changes—goes to zero as a4 becomes large regardless of the value of CU.
As noted above, the United Kingdom was excluded.
Subject to the usual caveats of the Lucas critique; in particular, the relative weight of forward and backward-looking elements in the inflation process may themselves depend on monetary policy.
Monetary policy is implemented in MULTIMOD in terms of an exogenous path for the target money supply. The actual money supply can differ in the short-run from the target, as the monetary authorities are assumed to smooth the interest rate changes that would be needed to keep money on target in each period.
The real exchange rate would also be unchanged. The open-interest parity condition implies that the real exchange rate depends on the differential between the domestic and foreign real interest rate: if real interest rates are unaffected, so is the real exchange rate.
Simulations were also run with a parameter of zero on future inflation, consistent with fully backward-looking models of price behavior. These results are not shown in Table 5 because, for some of the disinflation programs, the simulations exhibited potentially explosive cyclical behavior.
Fischer (1986, Chapter 7), indicates sacrifice ratios of 1.9-3.7 (assuming perfect credibility) for a simple model with three-year contracts. He concludes that imperfect credibility is required to square the model with historical disinflation experience.
See Fischer (1986, Chapter 8), who argues for the use of an exchange rate target in stabilization programs for this reason.
The conditions under which the exchange rate instrument can be abandoned without incurring much of a cost are discussed in the "optimum currency area" literature, pioneered by Mundell (1961). This issue is also considered in Fischer (1986, Chapter 8).