How Costly Will Reining in Inflation Be? It Depends on How Rational We Are

Jorge Alvarez and Allan Dizioli

No 2023/021, IMF Working Papers from International Monetary Fund

Abstract: We document that past highly inflationary episodes are often characterized by a steeper inflationslack relationship. We show that model-generated data from a standard small Dynamic Stochastic General Equilibrium (DSGE) model can replicate this empirical finding when estimated with different expectation formation processes. When inflation becomes de-anchored and expectations drift, we can observe high inflation even with a mildly positive output gap in response to cost-push shocks. The results imply that we should not use an unconditioned (not controlling for expectations change) Phillips curve estimated in normal times to predict the cost of reining in inflation. Our optimal policy exercises prescribe early monetary policy tightening and then easing in the context of positive output gaps and inflation far above the central bank target.

Keywords: DSGE; inflation dynamics; optimal monetary policy; forecasting and simulation; bayesian estimation; inflation-slack curve; expectations drift; shock decomposition; inflation episode; Inflation; Output gap; Real wages; Wage gap; Wages; Global (search for similar items in EconPapers)
Pages: 37
Date: 2023-02-03
New Economics Papers: this item is included in nep-ban, nep-cba, nep-dge and nep-mon
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