Inflation Bias, Time Inconsistency of Monetary and Fiscal Policies and Institutional Quality

Abstract

In developing countries, weak institutional quality can increase the probability of applying discretionary policies and can have a great impact on their double-digit inflation. Surico (2008) calculated inflation bias, but he considered just monetary policy and he did not pay attention to the institutions. Therefore, we design a model which considers the discretion in monetary and fiscal policies and the effect of the institutional quality. Then we calculate the inflation bias resulting from time inconsistency of monetary and fiscal policies by solving our model. In fact, we used a Barro- Gordon type model for our purpose. After solving the model, sensitivity analysis is done. The experimental results of the model, for Iran's economy as a developing country, show high degree of inflation bias during 1991-2016 , furthermore, the weak institutional quality have positive effects on inflation bias.