INSIDER POWER, UNEMPLOYMENT DYNAMICS AND MULTIPLE INFLATION EQUILIBRIA

This paper incorporates employment dynamics due to insider power into the Barro-Gordon theory of inflation. Unlike in the static Barro-Gordo n case, and even though our infinite-horizon model is linear-quadratic , there can be two Markov-perfect equilibria, so that the same unemplo yment may correspond to either low or high inflation. Both equilibrium inflation rates (measured per unit of the gap between the insiders' a nd government's employment targets) are higher than the corresponding rate in the static case. The low inflation equilibrium has intuitive c omparative-statics properties, in that inflation is increasing in insi der power and the discount factor, but the high inflation equilibrium behaves in the opposite way. The high-inflation equilibrium can be eli minated by a (future) precommitment to a fixed inflation regime (e.g. ERM), but only if this precommitment can be made with certainty. Contr ary to the static model, inflation may be lower when the union puts a positive weight on a wage target than when it cares only about employm ent, even when this wage target is consistent with a lower employment level than the employment target.