Insider Power, Unemployment Dynamics and Multiple Inflation Equilibria

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Abstract
This paper incorporates employment dynamics due to insider power into the Barro-Gordon theory of inflation. Unlike in the static Barro-Gordon case, and even though our infinite-horizon model is linear-quadratic, there can be two Markov-perfect equilibria, so that the same unemployment may correspond to either low or high inflation. Both equilibrium inflation rates (measured per unit of the gap between the insiders' and government's employment targets) are higher than the corresponding rate in the static case. The low inflation equilibrium has intuitive comparative-statics properties, in that inflation is increasing in insider power and the discount factor, but the high inflation equilibrium behaves in the opposite way. The high-inflation equilibrium can be eliminated by a (future) precommitment to a fixed inflation regime (e.g. ERM), but only if this precommitment can be made with certainty. Contrary to the static model, inflation may be lower when the union puts a positive weight on a wage target than when it cares only about employment, even when this wage target is consistent with a lower employment level than the employment target.

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