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Debt, Inflation, And Government Reputation
Job Market Paper
Abstract This paper introduces a dynamic game with incomplete information framework in order to understand how government reputation (agents' beliefs about the government's commitment to low inflation) impacts inflation, deficit, and debt choices and, therefore, the correlation between these variables. This game involves two players: wage setters that aim to have a stable wage over time, and a government that has inflation, output, and debt targets to peg. The classic time inconsistency of monetary policy problem is present in this model, in the sense that the government has an incentive to ``inflate away'' the wage of agents in order to boost output and reduce debt. To mitigate the time inconsistency problem, wage setters demand higher wages when the government's reputation is low. In equilibrium, the government's behavior depends crucially on its reputation: when it is low, the government finds it optimal to induce high output through elevated debt and inflation; and when its reputation is high, the government's best response is to generate low inflation that in turn is less correlated with debt. This model allows to study government's behavior under different regimes, providing a unified approach to understand both periods with high inflation with an elevated debt, as well as episodes of low inflation with a weak correlation with debt.
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