The inflation bias revisited: theory and some international evidence

The Kydland-Prescott, Barro-Gordon inflation bias result hinges on policymakers aiming at employment above potential. This has been questioned by academics and policymakers on the ground of realism. We show that even if policymakers target the normal level of employment, a bias arises if they are uncertain about economic conditions and are more sensitive to employment below than above normal. This view implies a positive association between inflation and the variance of output shocks. Cross-sectional empirical evidence from OECD economies supports this implication. We also discuss the consequences for the transparency of monetary policy and for central bank reform.