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Barro and Gordon: Rules, discretion, and reputation in a model of monetary policy

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Barro and Gordon. 1983. Rules, discretion, and reputation in a model of monetary policy. Journal of Monetary Economics 12: 101-121.

In Brief

The model looks something like this: Central bankers know that an unexpected increase in inflation will lower unemployment. It has to be unexpected, otherwise people would anticipate it (and there would be only nominal, not real, effects). Real effects only follow surprise. But if citizens are sophisticated, they will see that central bankers have this incentive. They will therefore anticipate the "unexpected" increase in inflation. To compensate, central bankers must make an even larger increase. It rapidly becomes apparent that this is the path to very high inflation. Therefore, to avoid this cycle, central banks should be bound in some way (i.e. an independent central bank with conservative leadership).