A POSITIVE THEORY OF INFLATION AND INFLATION VARIANCE

Empirically, inflation and the variance of inflation are positively associated. This paper develops a model that provides a potential explanation for this relationship in tern of the incentives facing the policymaker in a “discretionary equilibrium.” The model can also account for an empirical association between inflation and measures of real output instability. There is, however, no direct causal link whatever from the average rate of inflation to either the variance of inflation or that of real output.