Testing the Inflation Bias Hypothesis

This proposal describes three kinds of projects in monetary economics and macroeconomics all of which bear on the design of monetary institutions. The first project asks why many countries have gone through prolonged periods of costly, high inflation, as well as prolonged periods of low inflation and what can be done to prevent high inflation episodes from occurring again. One hypothesis is that there is a time inconsistency problem in monetary policy which induces an inflation bias: inflation rates without commitment are higher than they are under commitment. If this hypothesis is correct, it is important to redesign monetary institutions towards obtaining greater commitment.

I propose to test the inflation bias hypothesis by developing quantitative, general equilibrium monetary models in which monetary policy is set sequentially by optimizing, benevolent policy makers. I ask to what extent such models can account for the dynamics of macroeconomic variables like inflation, output and employment in the data. In two standard monetary models, a conventional cash-credit goods model and a limited participation model, there is no inflation bias for a large range of parameter values. In both models, the benefit of higher than expected growth in the money supply is a rise in output and the costs are distortions in relative prices. The monetary authority optimally balances the benefit and costs and it turns out that the costs of inflation outweigh the benefits. One deficiency of these models is that they do not reproduce the dynamics of observed money demand. This deficiency led to the construction of the endogenous cash-credit goods model, which introduces a financial intermediation technology to endogenize the distinction between cash and credit goods. This model seems more promising in that it is consistent with a key feature of the data: there are prolonged periods of high inflation and prolonged periods of low inflation, it also seems capable of accounting for the observed dynamics of inflation, output, employment and other variables.

The second project studies free rider problems and strategic delegation in monetary Unions. I seek to find out if a monetary union will induce strategic behavior by sovereign governments and whether or not member countries strategically manipulate the process of monetary policy decision making by selecting particular types of delegates. The answers depend critically on the extent to which monetary authorities can commit themselves to future actions. I show that in a large class of models, without commitment, strategic behavior produces inefficient outcomes so that it can be desirable to impose constraints on the policies of member governments as in the Maastricht Treaty governing the European Monetary Union. With commitment, such constraints are undesirable.

The third project studies informational cascades and financial crises with the object of develop models of herd behavior which may account for observations like the volatile capital flows into and out of developing countries. I extend existing models of herd behavior to allow for endogenous timing of risky investment decisions. I show that herds are more likely to occur. I then embed this model in an international setup and show that the model generates more volatile capital flows into and out of developing nations than between developed nations.