Credible Disinflation in Closed and Open Economies

We examine the credibility of disinflation policy in an economy with staggered wage contracts. The dynamic inconsistency of the government's optimal plan is the source of the credibility problem. If the government cannot commit to future actions, then the optimal plan is no credible. We argue the best the government can do in these circumstances is to follow the best consistent plan, which we compute as the perfect equilibrium to a game between the government and private-sector wage setters. Comparing the optimal plan to the consistent one indicates the latter can be considerably more costly and may involve a greater output loss and slower disinflation. We argue this provides a partial explanation for the large sacrifice ratios in the time series data. The ability to manipulate the exchange rate can lower the costs of disinflation in open economies, but the benefits largely evaporate when the government is restricted to consistent plans.