Inflation dynamics under optimal discretionary fiscal and monetary policies

Abstract

We examine the dynamic properties of inflation in a model of optimal discretionary fiscal and monetary policies. The lack of commitment and the presence of nominally risk-free debt provide the government with an incentive to implement policies which induce positive and persistent inflation rates. We show that this property obtains already in an environment with flexible prices and perfectly competitive product markets. Introducing nominal rigidities and imperfect competition has no qualitative but important quantitative implications. In particular, with a modest degree of price stickiness our model generates inflation dynamics very similar to those experienced in the U.S. since the Volcker disinflation of the early 1980s.