The prospect of European monetary union has revived interest in the credibility of low-inflation monetary policy. In Discussion Paper No. 702, Ali al-Nowaihi and Research Fellow Paul Levine develop a BarroGordon model for the case of multiple `reputational equilibria' arising when the private sector responds to inflation surprises with high wage inflation. The central bank pursues an inflation target while the private sector consists of unions that are concerned with real wages and employment but bargain with firms over the nominal wage. Inflation surprises reduce private-sector welfare and inflation reduces welfare for the private sector and for society as a whole.

The authors assume that the private sector responds to surprise inflation by increasing nominal wage demands. They derive a lower bound for the `punishment period' after which low inflation is restored. They find that a low-inflation outcome is enforceable if the private sector responds with such a `trigger strategy', but this will not be credible if the central bank chooses a deviation that is small enough for the private sector to do better by `acquiescing' and setting nominal wage increases at the original rate. They therefore propose a `chisel-proof' credibility condition which makes the punishment period depend on the size of deviation so that the `punishment fits the crime'. This result thus provides an enforceable low-inflation reputational equilibrium if central bankers are sufficiently far- sighted and the private sector's discount rate sufficiently low. For multi-period contracts, the central bank's discount rate is a function of contract length, so short-wage contracts may also help to achieve a low-inflation reputational equilibrium.

Monetary Policy and Reputational Equilibria: A Resolution of the Non-Uniqueness Problem
Ali al-Nowaihi and Paul Levine

Discussion Paper No. 702, August 1992 (IM)