CREDIBILITY AND CHANGES IN POLICY REGIME

This paper addresses the issue of credibility from an econometric pers pective. It develops a rational expectations model of inflation in whi ch the dynamics are driven by the level of government spending and by the effect of past inflation rates on the value of real taxes. Governm ent expenditure is modeled as an exogenous autoregressive process subj ect to discrete changes in regime. The regimes are defined by whether the level of spending is or is not consistent with the rate of inflati on targeted by the government as part of a stabilization program. In m aking their money demand decision, the agents need to construct probab ility inferences regarding the state of the expenditure process. Credi bility is quantified by the agents' inferred probability that the join t observation of inflation, the nominal interest rate, and government spending is generated by the reformed expenditure regime. In an applic ation to Israel, results indicate that the failed stabilization progra m of November 1984 was less than fully credible to the agents. The unc ertainty about the true nature of the expenditure process partially ex plains the volatility of the rate of inflation in this period. In cont rast, for the July 1985 program the agents correctly inferred a change in the regime driving the government spending process.