This paper analyzes the implications of optimal monetary policy for the dynamic behavior of inflation in a “natural rate” model characterized by endogenous unemployment persistence. We analyze a dynamic “insider outsider” model of the “Phillips Curve”, that accounts for the persistence of unemployment following nominal and real shocks. We derive optimal monetary policy under both discretion and commitment to an inflation target. We demonstrate that under discretion, because of the endogenous persistence of deviations of unemployment from its “natural” rate, deviations of inflation from target display the same degree of persistence as unemployment. Under full commitment to an inflation target there is no inflation persistence. An empirical investigation for the main industrial economies suggests that the persistence of deviations of inflation from a constant inflation target is of the same order of magnitude as the persistence of deviations of unemployment from its “natural” rate. This finding is consistent with the hypothesis put forward in this paper, of a clash between central bankers and labor market insiders, that causes both unemployment and inflation to persist.
Keywords: unemployment persistence, inflation, monetary policy, insiders outsiders, central banks
JEL Classification: E3, E4, E5