In recent years, countries of the European Monetary System (EMS) have pegged their exchange rates to the deutsche mark in an attempt to reduce their inflation to German levels. Inflation rates, however, have been slow to adjust. Indeed, from the evidence of European inflation indices over the 1987 period, the authors of a 1991 report on “Monitoring European Integration” conclude, “There is no doubt … that inflation convergence has not occurred and it is not occurring. The differential between higher-inflation countries and Germany has recently fallen; but this has been almost entirely due to a surge in the German inflation rate which is believed to be temporary.” (See Begg and others (1991), p. 45.) We examine three possible reasons for the sluggish inflation response observed in the EMS.
Some observers have stressed the role of staggered wage setting in perpetuating inflation, and they recommend synchronizing pay settlements as an institutional solution (see, for example, Layard (1990)). This paper begins, therefore, with an investigation of the link between inflation persistence and overlapping wage contracts in the rational expectations model of John Taylor (1979), in which wage settlements hold for two periods, but only one of the two groups of workers makes a settlement each period. We do find some inflation persistence, but only for one period. In the context of the European exchange rate mechanism (ERM), for example, upward inflation pressure from high wage settlements made in the past would soon be overwhelmed by the downward pressure from transitory unemployment and from expectations of a noninflationary future. The methods used to illustrate the transition readily suggest alternative strategies for setting the exchange rate on entry to the ERM. We consider, in particular, the options of devaluing to avoid the initial recession and of revaluing to stop inflation in its tracks. In a related model of staggered wage contracts developed by Guillermo Calvo (1983a, 1983b), in which the price level is an average of contracts of random length, neither of these options proves necessary, however, as there is no inflation persistence despite the contracts.
It should be stressed that two assumptions play a key role in the demonstration that overlapping contracts are consistent with low or no inflation persistence after the implementation of anti-inflationary monetary or exchange rate policy. The first is that a change in policy is fully credible: wage setters know about the new policy and do not anticipate any reversal. The second is the assumption of rational expectations: forecasts are made using a model of the inflation process that is assumed to be common knowledge, so that wage setters know how the policy will work and know that others do too. If implementing the anti-inflationary policy involves a major change of regime, as in joining the ERM, these assumptions may not be appropriate.
Thus, for instance, the government’s commitment to a fixed exchange rate pegged to the deutsche mark may not be fully credible, at least for a while. Until the final stage of European integration, realignments will always be possible. Moreover, European interest differentials prevailing during the first stage indicated that market makers gave some credence to the prospect of a revaluation of the mark against its more inflationary partners in the ERM (a belief that has been justified by recent events). So a period may occur—possibly quite prolonged—during which the members of the ERM gradually gain credibility for their policy of pegging to a hard currency.
To allow for the lack of full credibility in the peg, we assume that the private sector expects random realignments of the exchange rate. For convenience, we use a model with Calvo contracts, which implies that the inflation adjustment depends only on the speed with which people come to believe the exchange rate peg. If it takes time for the peg to become credible, the inflation generated in that time will cause the price level to “overshoot.” Thus, when inflation does finally fall to German levels, the economy will be uncompetitive, a problem that will only be corrected by price increases that are lower than the German rate of inflation. If the price level is sticky, due to overlapping of wage contracts, this disinflation will be associated with a prolonged contraction of output, triggered by the lack of competitiveness itself. By combining overlapping contracts and a lack of policy credibility, we can thus explain the emergence of stagflation after a regime change.
It may also be the case that the second assumption, that of common knowledge of beliefs, is also inappropriate to the modeling of ERM membership. Even if individual wage setters are persuaded that the authorities will pursue a hard-currency policy, they may be unsure of what others believe and be tempted to keep wage claims up as a consequence. Frydman and Phelps (1983) argue that this lack of “common knowledge” may explain the failure of Latin American stabilization policies. Could it also be relevant for the delay in stabilizing inflation in Europe?
To investigate the effects of a lack of common knowledge on inflation, we weaken the usual rational-expectations assumption by supposing that each agent fully believes in the peg but assumes that other agents do not and will take time to learn. We find that, although slow convergence of inflation may arise from this lack of common knowledge, it is less pronounced than that implied by the lack of policy credibility discussed above.
We conclude that the rapid convergence of inflation in the presence of overlapping wage contracts can be significantly undermined when the regime shift is not seen as fully credible. Our analysis is conducted with reference to two popular macroeconomic models of wage contracts. An alternative approach to explaining inflation inertia might be to explore the role of near-rational behavior by imperfectly competitive firms along the lines suggested by Akerlof and Yellen (1985).
APPENDIX I Stable Path with Taylor Contracts
From this equation, it is simple to check that the equilibrium level of x is
where K is a constant determined by an initial condition for xt – 1 and ρ is the stable root (the root that has an absolute value less than unity) of the characteristic equation
It is simple (but tedious) to check that p takes the following value:
To obtain an expression for the stable path observe that while on the stable path, equation A2 implies that the contract wage in period t – 1 is related to the contract wage in period t by the following expression:
This relation can be used to eliminate xt – 1 from equation (1), and after some rearrangement the following expression is found relating the current contract wage to the current price level:
where θ is the slope of the stable path. Using equation (A4) it follows that
which is the value of θ used in the text.
APPENDIX II Expected Realignments and Calvo Contracts
The assumed process for realignments implies that agents’ best forecast of the exchange rate at time τ based on information available at time t is
These equations can be solved to yield the following expressions for the expected price and output levels:
APPENDIX III Bayesian Learning About the Realignment Probability
The realignment expectations discussed in the text can be derived from a model of Bayesian learning, as shown in Driffill and Miller (1991). The argument may be summarized as follows.
After the exchange rate is pegged, the public still believes that realignments of size J may occur as a Poisson process, but the public is not sure of the intensity, π. Assume specifically that the uncertainty is simply whether the intensity is high (πH) or low (πL), and suppose the public starts out immediately after the peg with initial probability PH(0) and PL(0) = 1 – PH(0) attached to each intensity, so
where time t is measured from the date at which the rate was first pegged.
If a realignment occurs at time t, it causes a discrete jump in PH(t) so
Thereafter, PH will decline exponentially from its new high value just as in equation (A13), measuring time from the date of the realignment.
Note that for large values of t
thus, if πL = 0, then for large t
the result we use in the text.
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