DP702 Monetary Policy and Reputational Equilibria: A Resolution of the Non-Uniqueness Problem

Author(s): A Al-Nowaihi, Paul L Levine
Publication Date: August 1992
Keyword(s): Credibility, Monetary Policy, Multiple Equilibria, Reputational Equilibria
JEL(s): E52
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=702

This paper provides a resolution of the non-uniqueness of reputational equilibria in the Barro-Gordon monetary policy game. We introduce a `chisel-proof' credibility condition which ensures that in response to a small deviation from the low inflation rate by the central bank, it never pays for the private sector to acquiesce. This condition, which amounts to a refinement of the subgame perfect equilibrium, endogenizes the punishment length of the private sector's trigger strategy. The result is that a unique low-inflation outcome can be enforced as a sub-game perfect and credible non-cooperative equilibrium. A combination of discount factors close to unity for both players and short-wage contracts is the desirable combination to drive the best enforceable inflation outcome towards the ideal zero rate.