INFLATION VARIABILITY AND GRADUALIST MONETARY-POLICY

This paper considers the optimal approach to reducing inflation when t he cost of inflation is its conditional variability. Inflation is stoc hastically related to money growth, with unobservable time-varying aut onomous and induced components. A sharp reduction in money growth prov ides information about the responsiveness of inflation to money, but a lso induces variability as the economy heads into unknown territory. G radual policy is always optimal and the model explains why moderate-in flation countries adopt a much more gradual money growth reduction tha n high-inflation countries. Additionally, the analysis sheds light on the more general problem of learning with two unobservable parameters.