DP702 | Monetary Policy and Reputational Equilibria: A Resolution of the Non-Uniqueness Problem

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This paper provides a resolution of the non-uniqueness of reputational equilibria in the Barro-Gordon monetary policy game. We introduce a `chisel-proof' credibility condition which ensures that in response to a small deviation from the low inflation rate by the central bank, it never pays for the private sector to acquiesce. This condition, which amounts to a refinement of the subgame perfect equilibrium, endogenizes the punishment length of the private sector's trigger strategy. The result is that a unique low-inflation outcome can be enforced as a sub-game perfect and credible non-cooperative equilibrium. A combination of discount factors close to unity for both players and short-wage contracts is the desirable combination to drive the best enforceable inflation outcome towards the ideal zero rate.