A simple model of disinflation and the optimality of doing nothing

Abstract

Inertial factors are one the main reasons for the persistence of inflation and the high output losses of disinflation. However the removal of these factors can be costly in terms of popularity for the government : for example, unions may resist the reduction of lagged wage indexation. In this paper I construct a simple model exhibiting inflation inertia, and study the optimal stabilisation policy of a government that likes being in power, and whose disinflationary "abilities" are uncertain, under the assumption that removing inertial factors is costly. It is shown that the government can choose to "do nothing" on the inflation front or disinflate too little with respect to the social optimum because reducing inertial factors entails costs today but brings benefits in the future, when the current government may not be in power. It is also shown that these costs are worth bearing if initial inflation is sufficiently high: therefore it is possible to observe quick disinflations that however stop short of low inflation. This result is consistent with the disinflationary experiences of countries like Mexico and Israel, where inflation was reduced to low double-digit levels, but not further. The reason is that the "investment" in reducing inertia pays off handsomely when inflation is high, but may be less attractive if inflation is relatively low