STAGFLATIONARY CONSEQUENCES OF PRUDENT MONETARY POLICY IN A UNIONIZED ECONOMY

Stylised models of the policy game between monetary policy makers and the private sector have suggested that discretionary policy regimes suffer from an inherent inflationary bias and that pre-commitment to a target rate of inflation may be desirable. This paper shows that in the presence of labour unions, the monetary policy game can lead to radically different results: a central bank that is completely indifferent to the level of inflation may obtain outcomes with high employment rates and zero inflation while ‘prudent’, inflation-averse, central banks generate stagflation with positive inflation and low rates of employment.