Dynamic Macroeconomics

Figure 20.1
Inflation and lack of credibility under a discretionary policy.
Under discretion, the central bank does not achieve any of its social
objectives. Output and unemployment remain at their natural rates below full
employment. Equilibrium inflation turns out to be higher than the optimal
inflation rate, because of the rational adjustment of the inflationary
expectations of wage setters. As first pointed out by Kydland and Prescott
[1977] and Barro and Gordon [1983a] using related models of the
expectationally-augmented Phillips curve, if the natural rate of unemployment
is inefficiently high, discretionary policy aimed at achieving full employment
is characterized by an 
inflation bias
. The discretionary policy results in an

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equilibrium inflation rate higher than the central bank target, without any
effects whatsoever on equilibrium unemployment.
7
The social welfare loss under the discretionary policy is given by
where Λ
D
denotes the discounted social welfare loss from inflation and
unemployment under the discretionary policy.
To the extent that the natural rate of unemployment is inefficiently high,
there will be a positive inflation bias in a discretionary monetary policy that
aims for full employment. Monetary policy cannot permanently reduce
unemployment below its natural rate.
8
Policies other than monetary policy—such as labor market and tax
policies, which can affect the natural rate of unemployment—may be used for
that purpose.
9
Note that this theory of inflation, which is generally considered to be the
theory that explains the moderately high inflation rates in the industrial
economies in the late 1960s and the 1970s, is different from the theories of
high inflation based on the need for seigniorage revenues that we analyzed in
chapter 12. Seigniorage-revenue theories of high inflation are generally
considered to be more appropriate for economies with weak fiscal systems,
such as some less-developed economies, or economies that have emerged
from a major economic disruption (for example, a war).