Introduction

This chapter examines the determination of natural unemployment and inflation in a model setting corresponding to Kydland and Prescott (1977) and Barro and Gordon (1983a). The Kydland–Prescott and Barro–Gordon model is based on the assumption that the authorities have preferences which involve both inflation and employment goals while wage setters have preferences which involve only employment. Wage setters set the nominal wage in advance, forming correct expectations regarding the authorities' preferences and thus the authorities' sub-sequent policy reaction to a wage increase. It is a main conclusion in the traditional model that the authorities' preferences have no impact on natural production which results from the non-cooperative game between wage setters and authorities.

In difference to the traditional Barro–Gordon model, we assume that (i) the wage setters have preferences which involve both employment and the real wage, and (ii) the demand for goods can be affected by inflation. A distinction is made between expected inflation which is fully incorporated in nominal interest rate financial contracts, and unexpected inflation which causes a real wealth transfer between holders and issuers of nominal financial contracts. The inclusion of expected inflation as a determinant of the demand for goods can be explained by the mechanisms which were analysed in previous chapters, for example imperfect international integration of securities markets or imperfect competition in the markets for bank deposits and bank lending.