Self-conrming ination persistence

In this paper we simulate a central bank subject to the misperception that prices are indexed to past in‡ation in periods when …rms are unable to re-optimise. It thinks, in other words, that in‡ation is intrinsically persistent. The central bank sets monetary policy optimally subject to this belief. The central bank updates its beliefs about indexation using a constant gain learning scheme. The data generated by such policy lead to beliefs about in‡ation persistence being e¤ectively self-con…rming in a wide variety of setttings. Most importantly, ‡exible prices generate a steep Phillips curve under which the central bank’s policy actions have a powerful e¤ect on the process for in‡ation. These results o¤er a tentative answer to why it appears that in‡ation is persistent at some times and in some countries, and at others not. The answer is that changes in the degree of price stickiness and policy-makers’priors about in‡ation indexation can lead to large changes in reduced form in‡ation persistence.. This paper is preliminary and incomplete –please do not quote without the authors’permission. We thank, without prejudicing, for helpful conversations, Martin Ellison, Richard Harrison, Jan Vlieghe. The views expressed in this paper are those of the authors and not necessarily those of the Bank of England nor the Bank’s Monetary Policy Committee.