Asymmetric Policy Reactions and Inflation

Inflation determination is studied in a model in which policy makers care about inflation and the difference between actual and desired output as in Kydland and Prescott (1977) and Barro and Gordon (1983). We extend the analysis by assuming that desired output depends on the realisation of the supply shock, and show that this influences average inflation. Furthermore, we demonstrate that inflation is higher in countries experiencing more volatile output, as implied by the theory, and that the Federal Reserve reacted asymmetrically to output before 1980, which also supports the hypothesis that asymmetric policy responses influence steady-state inflation rates.