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© 2023 International Monetary Fund
WP/23/21
IMF Working Paper
Research Department
How Costly Will Reining in Inflation Be? It Depends on How Rational We Are
Prepared by Jorge Alvarez and Allan Gloe Dizioli
Authorized for distribution by Benjamin Hunt
February 2023
IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.
ABSTRACT: We document that past highly inflationary episodes are often characterized by a steeper inflation-slack relationship. We show that model-generated data from a standard small Dynamic Stochastic General Equilibrium (DSGE) model can replicate this empirical finding when estimated with different expectation formation processes. When inflation becomes de-anchored and expectations drift, we can observe high inflation even with a mildly positive output gap in response to cost-push shocks. The results imply that we should not use an unconditioned (not controlling for expectations change) Phillips curve estimated in normal times to predict the cost of reining in inflation. Our optimal policy exercises prescribe early monetary policy tightening and then easing in the context of positive output gaps and inflation far above the central bank target.
RECOMMENDED CITATION: Alvarez, Jorge, and Allan Dizioli. 2023. “How Costly Will Reining in Inflation be? It Depends on How Rational We Are.” IMF Working Paper 22/21, International Monetary Fund, Washington, DC.
| JEL Classification Numbers: | E2, E30, E52, E37, J6 |
| Keywords: | DSGE; inflation dynamics; optimal monetary policy; forecasting and simulation; bayesian estimation |
| Author’s E-Mail Address: | adizioli@imf.org, jalvarez@imf.org |
| JEL Classification Numbers: | E2, E30, E52, E37, J6 |
| Keywords: | DSGE; inflation dynamics; optimal monetary policy; forecasting and simulation; bayesian estimation |
| Author’s E-Mail Address: | adizioli@imf.org, jalvarez@imf.org |
Title page
WORKING PAPERS
How Costly Will Reining in Inflation Be?
It Depends on How Rational We Are
Prepared by Alvarez, Jorge, and Allan Gloe Dizioli*
Contents
I. Introduction
II. Literature Review
III. Stylized facts
IV. Model environment
A. Expectation formation processes
V. Data and Model Estimation
VI. Model simulation results
A. The inflation-slack curve through the lens of the model
B. Adaptive learning expectations could lengthen the high inflation episode
C. Optimal monetary policy discussion
D. Extension to an open economy model
VII. Conclusion
References
Appendices
A. Open economy model fit
Tables
1. In-Sample Forecast Performance for RE and AL Models
2. Out-of-Sample Forecast Performance for RE and AL Models
3. In-Sample Model Performance for RE and AL in Open Macro Model
4. Out-of-Sample Forecast Performance for RE and AL Models
Figures
1. Relationship between inflation pass-through and the inflation-unemployment gap slope
2. Highly inflationary cases: United States
3. Highly inflationary cases vs other: United States
4. Highly inflationary cases: Advanced Economies vs Emerging Markets
5. Highly inflationary cases: Mexico and Brazil
6. Highly inflationary cases vs other: Mexico and Brazil
7. Model generated data implies that the inflation-slack curve is steeper under adaptive expectations
8. Inflation is stickier when expectations are adaptive learning
9. Inflation converges more quickly to target with more forward-looking inflation in the RE model
10. The central bank should front-load tightening and then ease
11. US Shock decomposition in open macro model
12. Real exchange rate shock decomposition in open macro model
13. Expectations in Mexico appear more backward-looking than in the US
14. Model generated data implies that the inflation-slack curve is steeper under RE if inflation is driven by exchange rate shock
We would like to thank John Bluedorn, Daniel Leigh, Jesper Linde, Roland Meeks, Rafael Portillo, and Holly Wang for their helpful guidance and comments.