Citizens and Policymakers∗

We investigate the effectiveness of an aggressive price stabilizing (antiinflation) policy on the ability of citizens to achieve rational expectations equilibrium (REE) forecasts of inflation. Inflation does not persist when citizens have rational expectations forecasts. In using policy to assist citizens in achieving REE forecasts, policymakers also reduce inflation persistence. An aggressive anti-inflation policy tack consists of (among other things) a willingness to respond more forcefully to deviations from an inflation target. Using an adaptive learning framework, we develop a model that uses a real contracting rigidity in conjunction with an interest rate rule and an IS-curve. The model equilibrium indicates that only an aggressive anti-inflation policy enables citizens to learn the REE inflation forecast. The model also shows that inflation persistence has a negative relationship with policy aggressiveness. We test the model using quarterly inflation data for the period 1960 to 2000. The results indicate that policy becomes aggressive in the early 1980s. A substantial reduction in inflation persistence follows this change in policy. ∗ Note: Granato is Political Science Program Director, National Science Foundation, Suite 980, 4201 Wilson Boulevard, Arlington, Virginia, 22230 (e-mail: [email protected]). Wong is in the Department of Economics, University of Oregon, Eugene, Oregon 97403 (e-mail: [email protected]). The views and findings in this paper are those of the authors and do not necessarily reflect those of the National Science Foundation.