Discretionary Inflation in a General Equilibrium Model

This paper extends the Barro and Gordon (1983) model to a general equilibrium framework in which the costs and benefits to surprise inflation reflect the preferences, technology, and market structure of the economy. The benefit of such an approach is that we can relate the underlying features of the economy to the size of the inflation bias. In particular, it can be shown that an increase in the source of the monetary authority's incentive to inflate does not necessarily result in a worsened inflation bias due to offsetting changes in the cost of inflation. Furthermore, changes in the real interest rate affect the monetary authority's incentives and hence the discretionary level of inflation. Lastly, we can show that an increase in the labor share of national income worsens the inflation bias. The model also indicates the importance of a nominal rigidity, lack of policy precommitment, and a distortion for optimal monetary policy to be characterized by a level of discretionary inflation that exceeds the Friedman (1969) rule.