Working Papers

Authors: Gavin Cameron, Chris Wallace

Nov 2002

During the Bretton Woods era, OECD countries grew at historically unprecedented rates. This Golden Age has many possible explanations, ranging from the return to liberal policies in international trade to a backlog of profitable growth opportunities after the neglect of the 1930s and war-time damage. Eichengreen (1996) has argued the the proximate cause of the rapid growth was high investment, and that this high investment was made possible by certain institutions that were particularly well suited to reconstruction and growth. On the domestic side, these institutions led to high investment rates and moderate wage claims. This paper interprets the interaction between unions and firms as a coordination game. The risk-dominant equilibrium is selected via a global game argument. Only small changes to the payoffs are necessary to explain a change in the selected equilibrium, and therefore, the growth slowdown.

JEL Codes: N14, C70, E22

Keywords: coordination games, global games, risk-dominance, Bretton Woods, macroeconomic performance, institutions

Reference: 130

Individual View

Authors: Kathryn Graddy, Orley Ashenfelter, Princeton University and NBER

Nov 2002

This paper contains a review of the burgeoning research that has been designed to shed light on how the art auction system actually works and what it indicates about price formation. First, we find that in recent years returns on art assets appear to be little different from returns on other assets. In addition, some researchers have found that because of the weak correlation between art asset returns with other returns, there may be a case for the inclusion of art assets in a diversified portfolio. Second, we find evidence of several anomalies in art market pricing. The evidence clearly suggests that, contrary to the view of the art trade, masterpieces underperform the market. In addition, there is considerable evidence that there are fairly long periods in which art prices may diverge across geographic areas and even auction houses. Third, we review the public record of the criminal trial of Sotheby`s former Chairman, who was accused of price fixing, to show how the collusion with Christie`s, the other great public auction house, was actually engineered. Contrary to the way the proceeds from the settlement of the civil suit in this case were distributed, we show that buyers were almost certainly not injured by the collusion, but that sellers were. In addition, based on the public record of settlement, it appears that the plaintiffs in the civil suit were very handsomely repaid for their injury. Finally, we review the extensive research on the effects of the auction institution on price formation. There is now considerable theoretical research on strategic behavior in auctions, much of it in response to empirical findings, and we review three key findings. First, the evidence suggests that art experts provide extremely accurate predictions of market prices, but that these predictions do not optimally process the publicly available information. Second, high reserve prices, and the resulting high unsold (buy-in) rates are best explained as optimal search in the face of stochastic demand. Third, extensive research has documented that the prices of identical objects are more likely to decline than to increase when multiple units are sold, and this has led to considerable theoretical research. Subsequent empirical research has tended to document declining demand prices even when the objects are imperfect substitutes.

JEL Codes: D44, G11, L12

Keywords: auctions, art, price anomalies, asset returns, price fixing

Reference: 131

Individual View

Authors: Ernesto Dal Bo

Nov 2002

When optimal policymaking is subject to dynamic inconsistencies (Kydland and Prescott, 1977), but shocks hit the economy after private agents form expectations, there is a trade off between the need to commit to a policy, and the need to retain discretion so as to respond to shocks. Rogoff (1985) shows that a way to strike the right balance between commitment and flexibility in monetary policy is to appoint a conservative central banker. I show that a rationale for using a committee to make decisions through voting is that a commitment device can be created out of it, without totally renouncing flexibility to respond to unexpected contingenices. Appropriate voting procedures and a well chosen supermajority rule can make a randomly sampled committee behave like Rogoff`s optimally conservative central banker. The model is developed for the case of monetary policy but these insights are more general (extending to capital taxation and patent protection). Supermajority rules can mitigate time inconsistency by introducing a status quo bias. When voting institutions (ie. the committee`s constitution) are endogenously chosen by simple majority voting, the emerging majority rule is the supermajority yielding the mix of commitment and flexibility preferred by the median voter. A corollary to this provides a theory of why constitutional reform typically requires the approval of a supermajority.

JEL Codes: D71, D72, E58, H11

Keywords: supermajorities, committees, commitment versus flexibility, voting, endogenous institutions, endogenous constitutions

Reference: 132

Individual View

Authors: Oliver Board

Nov 2002

The epistemic program in game theory uses formal models of interactive reasoning to provide foundations for various game-theoretic solution concepts. Much of this work is based around the (static) Aumann structure model of interactive epistemology, but more recently dynamic models of interactive reasoning have been developed, most notably by Stalnaker[39] and Battigalli and Siniscalchi [6], and used to analyze rational play in extensive form games. But while the properties of Kripke structures are well understood, without a formal language in which belief and belief revision statements can be expressed, it is unclear exactly what are the properties of these dynamic models. Here we investigate this question, by defining such a language. A semantics and syntax are presented, with soundness and completeness theorems linking the two.

JEL Codes: C73, D82, D83

Keywords: interactive epistemology, belief revision, semantic, syntactic

Reference: 125

Individual View

Authors: Christopher Adam, David Bevan

Oct 2002

This paper examines the relation between fiscal deficits and growth for a panel of 45 developing countries. Based on a consistent treatment of the government budget constraint, it finds evidence of a threshold effect at a level of the deficit around 1.5% of GDP. While there appears to be a growth payoff to reducing deficits to this level, this effect disappears or reverses itself for further fiscal contraction. The magnitude of this payoff, but not its general character, necessarily depends on how changes in the deficit are financed (through changes in borrowing or seigniorage) and on how the change in the deficit is accommodated elsewhere in the budget. We also find evidence of interaction effects between deficits and debt stocks, with high debt stocks exacerbating the adverse consequences of high deficits.

JEL Codes: H3, H6, O4

Keywords: fiscal defcits, growth, threshold effects, developing countries

Reference: 120

Authors: John Knight,Linda Yueh

Oct 2002

Social capital is thought to play an economic role in the labour market. It may be particularly pertinent in one that is in transition from an administered to a market-oriented system. One factor that may determine success in the underdeveloped Chinese labour market is thus guanxi, the Chinese variant of social capital. With individual-level measures of social capital, we test for the role of guanxi using a data set designed for this purpose, covering 7,500 urban workers and conducted in early 2000. The basic hypothesis is supported. Both measures of social capital - size of social network and Communist Party membership - have significant and substantial effects in the income functions. Indeed, social capital may be just as important as human capital: remarkably, one additional reported contact contributes more than one additional year of education. Social capital can have influence either in an administered system or in one subject to market forces. We find that it does so in both parts of the labour market, but some of the evidence suggests that it is more important in the latter.

JEL Codes: J30, J40

Keywords: labour markets, wages, social capital, social networks, China

Reference: 121

Authors: David Vines, Gordon Douglas Menzies, Economic Research Department, Reserve Bank of Australia.

Oct 2002

We develop a stylized real model of the Asian crisis where an adverse extenal shock can lead to real exchange rate overshooting. Domestic borrowers of foreign capital are bound by debt contracts even when the capital is unable to earn the world rate of return. Following an adverse shock, the requirement to honour these debt contracts leads to a debt overhang. In the long run, when capital becomes mobile, extra-marginal projects are shut down as capital departs, and the real exchange rate falls by more than the terms of trade shock. In the short run, the real exchange rate is partly determined by demand conditions by means of what we call the wage and overhang multipliers. For reasonable production and consumption parameters, the short run real exchange rate - driven by the wage and overhang multipliers - overshoots its long run value.

JEL Codes: F11, F31

Keywords: Asian crisis, exchange rate overshooting, mulitplier, overhang

Reference: 122

Individual View

Authors: Christian List

Oct 2002

Drawing on the so-called `doctrinal paradox`, List and Pettit (2002a) have shown that, given an unrestricted domain condition, there exists no procedure for aggregating individual sets of judgments over multiple interconnected propositions into corresponding collective ones, where the procedure satisfies some minimal conditions similar to the conditions of Arrow`s theorem. I prove that we can avoid the paradox and the associated impossibility result by introducing an appropriate domain restriction: a structure condition, called unidimensional alignment, is shown to open up a possibiity result, similar in spirit to Black`s median voter theorem (1948). Specifically, I prove that, given unidimensional alignment, propositionwise majority voting is the unique procedure for aggregating individul sets of judgments into collective ones in accordance with the above mentioned minimal conditions.

JEL Codes: D71, D72

Keywords: aggregation, beliefs, propositional logic, domain restriction, unidimensional alignment

Reference: 123

Individual View

Authors: Natalie Gold, Christian List

Oct 2002

A `framing` effect occurs when an agent`s choices are not invariant under changes in the way a choice problem is formulated, e.g. changes in the way the options are described (violation of description invariance) or in the way preferences are elicited (violation of procedure invariance). In this paper we examine precisely which classical conditions of rationality it is whose non-satisfaction may lead to framing effects. We show that (under certain conditions), if (and only if) an agent`s initial dispositions on a set of propositions are implicitly inconsistent, her decisions may be path-dependent, i.e. dependent on the order in which the propositions are considered. We suggest that different ways of framing a choice problem may induce the order in which relevant propositions are considered and hence affect the decision made. This theoretical explanation suggests some observations about human psychology which are consistent with those made by psychologists and provides a unified framework for explaining violations of description and procedure invariance.

JEL Codes: D11, D80

Keywords: framing, preference reversal, path-dependence, rationality, deductive closure

Reference: 124

Individual View

Authors: Daniel John Zizzo

Sep 2002

The experiment presented in this paper employs 3x3 games to analyze how perception of a game affects behavior in the presence or absence of a minimal framing effect and of uncertainty about the values of some game payoffs. We vary the harmony of practice stage games, and explain how this changes later behavior. We employ techniques, such as payoff integration and similarity evaluations, that could be used in further research to open the black box of framing effects. Game harmony is a measure summarizing how harmonious the interests of the players are in the game. It is associated with cooperation.

JEL Codes: C72, C91, D83

Keywords: 3 x 3 games, game harmony, cooperation, cognitive game theory

Reference: 118

Individual View

Authors: Christine Greenhalgh

Sep 2002

The thesis of this paper is that a free-market capitalist economy is biased against supplying basic needs of poor consumers and also biased against creating inventing and using green technology. We begin by identifying the patterns of perverse logic in the system of market supply and in the process of technological advance under capitalism. The first pivotal problem is that economic decision makers place too high a value on the time of the current generation of workers. Hence capitalist markets create and use technologies to produce goods and services that are geared to saving worker and consumer time, instead of being geared to conserving scarce non-renewable resources. A second bias arises because of the existing inequality of wealth and the differential price of time between the rich and the poor. Demands for positional goods for the rich, which are time saving and resource using, crowd out demands to meet basic needs of the poor. Entrepreneurs react by satisfying the dominant, but wasteful, market demands of the rich, both in current supply and by responding to incentives to invent new products and processes that appeal to the rich. This has a further consequence in accentuating inequality, as prices fall and quality rises for products subject to innovation, and in driving up the relative price of skilled labour yet further, refueling the cycle of labour saving innovation at the expense of the environment. Policy to redress these perverse pressures must be far more radical than those currently under discussion in either the `Green` or the `Poverty` forums. We argue for rethinking definitions of private property rights, to attach more importance to use rights than to ownership rights, where the corollary is that lack of use can cause loss of ownership. Although a wealth tax is an obvious first step in reducing the power of the rich to distort production towards resource intensive goods, it is never likely to be sufficient. Within consumption and production, policy should aim to increase the rate of utilisation of all durable consumer goods and productive capital. This requires incentives which promote rental markets for privately owned durables and restore shift working to ensure better capacity utilisation. The taxation of production could also change: incentives to business should be restructured to maximise the use of renewable resources, particularly of unskilled labour, and minimise the use of materials intensive techniques leading to the depletion of reserves and the creation of waste products. Finally the rewards to invention and innovation, whether through R&D tax credits or the award of intellectual property rights, must circumvent the present bias of invention for today`s rich in order to address the needs of today`s and tomorrow`s poor.

JEL Codes: O30, H20

Keywords: efficiency, equity, technology

Reference: 119

Individual View

Authors: Daniel John Zizzo

Sep 2002

Game harmony is a generic game property that describes how harmonious (non-conflictual) or disharmonious (conflictual) the interests of players are, as embodied in the payoffs. Pure coordination games are games of complete harmony,and constant-sum games are games of pure disharmony: the majority of games is somewhere in the middle. This paper provides measures of game harmony that can be used to classify normal form games, and analyzes their properties. Game harmony is positively associated with cooperation, and we review evidence that this is so. Framing effects increasing cooperation may work by increasing perceived game harmony.

JEL Codes: C72, H41

Keywords: game harmony, game classification, framing effects, social dilemmas.

Reference: 116

Individual View

Authors: Daniel John Zizzo, Jonathan H.W. Tan

Sep 2002

This paper presents an experimental test of the relationship between game harmony and cooperation in 2 x 2 games. Game harmony measures describe how harmonious (non-conflictual) or disharmonious (conflictual) the interests of players are, as embodied in the payoffs: coordination games and constant-sum games are examples of games of perfect harmony and disharmony, respectively, with most games being somewhere in the middle. In our experiment we consider a variety of 2 x 2 games, including amongst others the Prisoner`s Dilemma, the Stag-Hunt, the Chicken, a coordination game and three variants of trust games. We find that simple game harmony measures can explain 2/3 (or more) or the variance in mean cooperation rate across these games.

JEL Codes: C72, C91, H41

Keywords: game harmony, cooperation, 2 x 2 games, trust games, social dilemmas.

Reference: 117

Individual View

Authors: Oliver Grant

Sep 2002

This paper presents new estimates of income inequality derived from Prussian tax statistics for the years 1822-1914. Confidence intervals are also calculated. The results show a rise in inequality in the nineteenth century, with a peak around 1906, thus supporting the view put forward by Simon Kuznets that industrialisation will initially lead to a rise in inequality. The paper goes on to consider whether this was due to factors which were particular to Germany in the period, or whether the Kuznets curve is the result of forces which affect all industrialising societies. The conclusion reached is that the Kuznets curve is an avoidable trap, not an automatic consequence of industrialisation.

Reference: 048

Individual View

Financial conglomerates combine banking, insurance and other financial services within a single corporation. In this non-technical paper I consider the rationale for capital regulation in such firms and I examine some current policy questions in the light of this discussion. My first conclusion is that the different institutional structure of bank and insurance companies mitigates against harmonisation of capital requirements across different conglomerate businesses. I also question the received industry view that regulators should account for diversification effects at the holding company level.

Reference: 2002-FE-08

This paper presents estimates of agricultural productivity (net value added per full-time labour unit) for 21 German regions for the years 1880/4, 1893/7 and 1905/9. The estimates are derived from regional accounts for agricultural production and costs. The methods used to draw up these accounts are discussed, and there is also an analysis of Hoffmann’s national agricultural accounts. The estimates show that productivity in East-Elbian agriculture was growing rapidly in the period, and tending to converge on the German average. Productivity in southern Germany was not growing so fast. The reasons for this improvement east of the Elbe are examined using a Kreis-level data set. This shows that yield improvements were not limited to large farms and estates, but that smaller holdings also had access to new technology and improved husbandry methods. In short, East-Elbian agriculture should not be seen as backward or bound by tradition: it was a modern sector capable of rapid improvements in techniques and methods of production.

Reference: 047

Individual View

Authors: Simon GB Cowan, Simon Cowan

Jul 2002

The paper shows how commodity taxes can provide insurance to consumers when the producer price is volatile. Specific and ad valorem taxes have differing roles. The optimal specific tax is positive when demand has some elasticity. The optimal ad valorem rate is zero when demand is unit-elastic, negative when demand is inelastic and positive for elastic demand. When both types of taxes are used in general the specific tax is positive and the ad valorem rate is negative. The model also applies to the problem in public utility regulation of determining how retail prices should move with wholesale or fuel prices.

JEL Codes: H21, L51

Keywords: commodity taxation, price regulation

Reference: 110

Authors: Sujoy Mukerji, Jean-Marc Tallon, EUREQua, CNRS, Universite Paris I

Jul 2002

This paper analyzes optimal wage contracting assuming agents are not subjective expected utility maximizers but are, instead, ambiguity (or uncertainty) averse decision makers who maximize Choquet expected utility. We show that such agents will choose not to include any indexation coverage in their wage contracts even when inflation is uncertain, unless the perceived inflation uncertainty is high enough. Significantly, the exercise does not presume any exogenous costs (e.g. transactions costs) of including indexation links.

JEL Codes: D81, J31

Keywords: wage contracts, indexation, inflation, uncertainty

Reference: 111

Individual View

Authors: Sujoy Mukerji

Jul 2002

This paper provides a positive theory about the contractual form of procurement contracts under cost uncertainty. However, while the cost of manufacture is uncertain it can be reduced by an amount depending on the extent of effort exerted by the agent. The effort exerted by the agent is not verifiable but causes disutility to the agent, hence, its extent will ultimately depend on the power of incentives built into the terms of reimbursement agreed to in the contract. The analysis in the paper explicitly models the possibility that the agent’s beliefs are ambiguous and the agent is ambiguity averse. The principal finding is that the greater the ambiguity/ambiguity aversion of the agent, the lower the power of the incentive scheme incorporated in the terms of reimbursement included in the optimal contract.

JEL Codes: D800, D810, D820, D89

Keywords: procurement, incentive contracts, uncertainty aversion, cost-plus contracts, fixed price contracts

Reference: 112

Authors: Valerie Lechene, Martin Browning, Institute of Economics, Copenhagen, Denmark.

Jul 2002

It is universally accepted that children have important effects on household demand patterns. This is usually attributed to the direct effect of children; for example children are food intensive. Alternative inferences are that the observed correlations between children and demand patterns are due to non-direct effects, such as fixed effects, state dependence or intra-household effects. These non-direct effects make the consistent estimation of direct effects problematic. We employ a French family expenditure survey that has a number of unusual features to explore the source of the correlation between children and demands. In a first set of tests, we use a sample of older households (over-55`s) for whom we have the details of their completed fertility and whether or not they currently have children living at home. We consider only those who do not have children currently living at home. If there are only direct effects then the demand patterns of those who have had children should be the same as those who never had children. We find that this is not the case. For the second set of tests, we use a sample of couples aged up to 55 and test for the exogeneity of children variables using background variables as instruments for children. We find that children are not exogenous for some goods. These two findings together cast doubt on the usual practice of identifying direct children effects with the coefficients on the children variables in demand equations.

JEL Codes: D12, J13

Keywords: children, demand, fixed effects, state dependence, intra-household effects

Reference: 16

Authors: Sujoy Mukerji, Peter Klibanoff, Northwesern University Massimo Marinacci, Dip. di Satistic e Matematica Applicata, Universita di Torino and ICER

Jul 2002

We propose and axiomatize a model of preferences over acts such that the decision maker evaluates acts according to the expectation (over a set of probability measures) of an increasing transformation of an act`s expected utility. This expectation is calculated using a subjective probability over the set of probability measures that the decision maker thinks are relevant given her subjective information. A key feature of our model is that it achieves a separation between ambiguity, identified as a characteristic of the decision maker`s subjective information, and ambiguity attitude, a characteristic of the decision maker`s tastes. We show that attitudes towards risk are characterized by the shape of the von Neumann-Morgenstern utility function, as usual, while attitudes towards ambiguity are characterized by the shape of the increasing transformation applied to expected utilities. We show that the negative exponential form of this transformation is the special case of constant ambiguity aversion. Ambiguity itself is defined behaviorally and is shown to be characterized by properties of the subjective set of measures. This characterization of ambiguity is formally related to the definitions of subjective ambiguity advanced by Epstein-Zhang (2001) and Ghirardato-Marinacci (2002). One advantage of this model is that the well-developed machinery for dealing with risk attitudes can be applied as well to ambiguity attitudes. The model is also distinct from many in the literature on ambiguity in that it allows smooth, rather than kinked, indifference curves. This leads to different behavior and improved tractability, while still sharing the main features (e.g. Ellsberg`s Paradox, etc.). The Maxmin EU model (e.g., Gilboa and Schmeidler (1989)) with a given set of measures may be seen as an extreme case of our model with infinite ambiguity aversion. Two illustrative applications to portfolio choice are offered.

JEL Codes: D800, D810

Keywords: ambiguity, uncertainty, ambiguity aversion, uncertainty aversion, Ellsberg Paradox

Reference: 113

Individual View

Authors: Sujoy Mukerji, Jean-Marc Tallon, CNRS-EUREQua, Universite Paris I

Jul 2002

Results in this note relate the observation of an interval of prices at which a DM strictly prefers to hold a zero position on an asset (termed `bid-ask behavior`) to the DM`s perception of the underlying payoff relevant events as ambiguous, as the term is defined in Epstein and Zhang (2001). The connection between bid-ask behavior and ambiguity is established without invoking a parametric preference form, such as the Choquet expected utility or the max-min multiple priors model. This allows us to draw an observable distinction between bid-ask behavior that may arise purely due to first-order risk aversion type effects, such as those which could arise even if preferences were probabilistically sophisticated, and the bid-ask behavior that involve ambiguity perceptions.

JEL Codes: D810

Keywords: Ellsberg Paradox, bid-ask spread, testing for ambiguity aversion, uncertainty aversion, unforeseen cointingencies, subjective state spaces.

Reference: 114

Authors: M. Asghar ZaidiKlaas de Vos, CentER Applied Research, Tilburg University, The Netherlands

Jul 2002

This paper presents an empirical analysis of the income mobility of older people in Great Britain and the Netherlands, using longitudinal data from the British Household Panel Survey (BHPS) and the Dutch Socio-Economic Panel (SEP) for the period 1991 to 1997. Using the full potential of the panel data and applying appropriate regression analyses, we aim to quantify the impact of various life transitions and attributes on the income of older people in the two countries. An introductory perspective is provided by a brief investigation of the relative economic status of the older population in both countries. We find that the Dutch elderly are on average better-off than their British counterparts, and that the relative position of the elderly has improved in both countries during the 1990s. This improvement, however, was almost entirely due to the better economic status of newly retired people who retire with incomes in addition to the basic state pension. We also provide a brief comparison of the pension systems operating in the two countries. The Dutch basic pension scheme is more generous than the British and, in general, the occupational pension schemes in the Netherlands also appear to be more rewarding in terms of earnings` replacement, in provisions for early retirement and in their coverage for survivors. The empirical analysis on income mobility makes use of appropriate bivariate and multivariate tools. Equivalised household income is used to measure income mobility, and is smoothed over two years in order to reduce the impact of transitory fluctuations. Explanatory variables based on demographic and labour market attributes, as well as income, time–period, and sample attributes, are used to identify factors associated with income mobility in old age. The results show that British elderly are more likely to experience income mobility than their Dutch counterparts. The mobility differential between the two countries is observed for both upward and downward income mobility. This differential is particularly noticeable for long-range upward income mobility (i.e. rises in annual income exceeding 15%). Undoubtedly, some of the income mobility and the differences between both countries may be artefacts due to measurement errors, but it can be safely concluded that for most people old age is not a period of stable fixed incomes. The multivariate analysis of income mobility suggests that a number of demographic, labour market and income attributes significantly correlate with income mobility. In particular, the events of widowhood and changing living arrangements appear to have a notable impact on incomes of older people in both countries. The transition into widowhood is associated with both upward and downward income mobility in the Netherlands, but only with downward income mobility in Great Britain. This differential effect will largely be a consequence of differences in individual entitlements to basic pension for women in the two countries. A change in living arrangements of older people is associated with a higher likelihood of upward as well as downward income mobility in both countries. This empirical exercise highlights the benefits and pitfalls of cross-national research on income dynamics within old age. Improvements in data quality and comparability as well as in methodology are necessary before clear scientific and policy conclusions may be drawn. This study should therefore be considered as a first step in our work on analysing income mobility in old age. Nonetheless, the results provide some pointers towards how the different social security systems affect the income risks associated with various attributes and life-course transitions experienced by older people.

JEL Codes: D31, D63, H55, I32, J14

Keywords: income mobility, old age, life-course events, Great Britain, The Netherlands

Reference: 107

Individual View

Authors: David P. Myatt, Stephen D. Fisher

Jul 2002

Intuition tells us that strategic voting is most likely in marginal constituencies where the preferred party is a long way behind the second placed parity. Some formal theories suggest there should be complete desertion of all but two candidates (Palfrey 1989), or additionally that the second and third will have similar vote shares (Cox 1997). Unfortunately, these theories fail to account for uncertainty over the strength of candidates. We present a model that allows for such uncertainty. It generates interesting and original comparative statics. All three approaches are tested against English voting data from 1987, 1992 and 1997. Our model fits the data; the standard intuition and Cox hypothesis do not. Thus formal theory can improve on intuition. But, this depends on the realization that voters are uncertain, and it is only uncertainty that matters for strategic voting.

JEL Codes: D72

Keywords: strategic voting, tactical voting, Duverger’s Law, plurality rule, elections

Reference: 115

Individual View

Authors: Richard Mash

Jul 2002

The paper presents a monetary policy model with an endogenous capital stock when a backward looking element in wage setting causes inflation persistence. We analyse how the endogeneity of the capital stock changes the macroeconomic dynamics with which policy interacts and its implications for optimal policy and time inconsistency. Capital stock endogeneity makes inflation more persistent in reduced form. This makes the optimal contemporaneous policy response to shocks more vigorous but the subsequent return to steady state more gradual. Observed output becomes more serially correlated. Capital endogeneity can also give rise to disinflation bias under discretion for some parameter values.

JEL Codes: E52, E58, E22, C61

Keywords: monetary policy, time inconsistency, inflation persistence, investment, capital stock

Reference: 108

Individual View

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