Abstract
Due to pressure from some lobbies, the government is unwilling to perform structural reforms. The probability of its re-election depends, however, on a positive business cycle. The central bank may create surprise deflation even though it maximizes the public's utility function and even if it faces a rational market. This may explain why the European Central Bank (ECB), but not the US Federal Reserve (FED), is found to be unaffected by the inflation bias.
Notes
1 The Security Market Programme (SMP) is defined as ‘Interventions by the Eurosystem in public and private debt securities markets …’, see the European Central Bank's (ECB's) website.
2 The ECB wrote an official letter to the Italian government in the summer of 2011 indicating urgent policies aimed at increasing the potential output. Furthermore, in the press conference on 3 November 2011, ECB President Draghi hinted that the purchase of (Italian) government bonds within the SMP is conditional on the implementation of the indicated reforms.
3 If the government's utility function includes the welfare function, the government should also consider the decrease in this function once the central bank creates surprise deflation.
4 This FOC holds in election periods (t, t + 2, …). In order to find the FOC in nonelection periods, set PGt
= 1 in EquationEquation 6.(6)
5 Around a null value of the output gap.
6 Provided that .
7 Provided that .
8 Absent in the standard time-inconsistency models.