The Inflation Bias Hypothesis and Monetary Policy in the Open Economy

National Bureau Of Economic Research Inc, Cambridge MA

Investigators

Abstract

The author proposes research to help identify ways of improving monetary policy in both closed and open economy settings. The first project would explore one hypothesis about the reasons market economies undergo prolonged periods of low and high inflation. The inflation bias hypoth-esis suggests that the periodic episodes of costly high inflation reflect a weakness in the design of monetary institutions in that they do not confer monetary policy makers with the ability to cred-ibly commit to consistently low inflation policies. To test the inflation bias hypothesis, the author proposes to incorporate the various costs and benefits of inflation into general equilibrium models with an optimizing monetary authority which lacks a commitment technology. The advantage of using general equilibrium models is that they have implications for a wide array of data. In this way a large amount of information, not just data on inflation and output, can be brought to bear in the models' design and construction. The author argues that if the resulting model can account for the observed level and volatility of inflation, then we should have greater confidence in the inflation bias hypothesis and in its implication that improvements in monetary policy require redesigning monetary institutions to incorporate greater commitment. The author reports some initial results based on analyzing two conventional general equi-librium models. He finds that these models do not support the inflation bias hypothesis, and that they imply there is little to be gained in the redesign of monetary institutions. However he also reports that the models' implications for money demand are poor. Moreover, he shows that when changes in the models' intermediation technologies are introduced to improve their money demand implications, then the inflation bias hypothesis is resuscitated. On this basis, the author proposes to undertake additional work on the modeling of intermediation technologies in order to develop a credible evaluation of the inflation bias hypothesis. A convincing test also requires that the model do well in accounting for a broader set of variables. Accordingly, the author plans to extend existing models so that they incorporate capital accumulation and government fiscal variables such as debt and taxes. The author expects that the research will help shed light on other issues including various puzzles in the empirical money demand literature and puzzling features of hyperinflation episodes. The second project would help shed light on the causes and remedies for financial crises experienced by a number of emerging market economies. The author seeks to gain new insights into these experiences by analyzing models which emphasize the foreign and domestic working capital requirements of firms. He proposes research designed to help shed light on the ap-propriate monetary policy to follow in the immediate aftermath of a crisis. He presents preliminary results which suggest that the nature of the monetary transmission mechanism in 'crisis' times may be very different than what it is in 'normal' times. The author also proposes to study alterna-tive monetary regimes, including dollarization, to see which is most likely to produce good results. In this work, he plans to take into account the various shocks affecting particular emerging market economies, including shocks to expectations. The proposed research would involve constructing quantitative general equilibrium models of small open economies. The construction and parameter-ization of these models would be guided by empirical analysis of individual countries. The research also entails an empirical investigation of what happens in the aftermath of a crisis, including the analysis of the type of collateral constraints that may be imposed at that time. There are two additional projects. One would explore, with the use of quantitative general equilibrium models, recent concerns that have been raised about the supposed dangers of low nominal rates of interest. Another would investigate the monetary transmission in an economy with a large number of firms of different ages and productivity.