Essays on discretionary inflation

The focus of the following three essays rests on the Kydland-Prescott (1977) and Barro-Gordon (1983) model of time inconsistent discretionary monetary policy. The first essay derives a model in which the costs and benefits to inflation are tied to the underlying features of the economy. The benefit to inflation arises due to monopolistic competition among firms and the cost is due to a staggered timing structure for nominal money. The benefit of this approach is that it can be shown that factors that increase the monetary authority's incentive to inflate may also increase the costs to inflation, and therefore do not necessarily result in a worsened inflation bias. In particular, the model shows that discretionary inflation in the economy is nonmonotonically related to the distortion. The model also indicates that changes in the real interest rate affect the monetary authority's incentives and hence the discretionary rate of inflation. An increase in the labor share raises the discretionary rate. Lastly, lack of commitment, costs to inflation, and the presence of a distortion are crucial for discretionary inflation to be biased above the Friedman (1969) rule. The second essay builds on the first, extending the model to an open economy environment. The extended model indicates several channels through which openness affects the monetary authority's incentives. Most significantly, the model cannot replicate the Romer (1993) and Lane (1995) result that openness reduces the discretionary rate of inflation. Again, the model relates the underlying features of the economy on the discretionary rate, and an economy's foreign asset position. Strategic incentives are also important for determining whether an open economy's rate of inflation is less than that of a comparable closed economy. The last essay analyzes empirically the relationship between the overall degree of competition among firms, as measured by the markup, and the average rate of inflation for the OECD group of countries. In line with the time-consistency argument, results indicate a positive relationship between markups and inflation. This finding is robust to the inclusion of several explanatory variables, such as terms of trade effects, and central bank independence. The evidence is weak, however, in the presence of per capita GDP.Arts, Faculty ofVancouver School of EconomicsGraduat