A Theory of the Intergenerational Dynamics of Inflation Beliefs and Monetary Institutions

We develop a stochastic overlapping-generations model with endogenously evolving heterogeneous beliefs on the degree of inflation protection to be provided by markets versus the monetary authority. It incorporates adaptive learning from inflation history and imperfect empathy in the cultural transmission of beliefs. Analytical results on endogenous inflation beliefs and socially-optimal inflation are derived first in a within-generation voting equilibrium that defines a particular degree of inflation aversion of a society's monetary institution. Then further theoretical and simulation analysis of the intergenerational dynamics of inflation and inflation beliefs provides insights into the long-run evolution of population types and social institutions, exploring the interactions of three central forces: the persistence of inflation, the degree of inflation aversion of the central bank and the recurrent irregular cycles of agent type proportions and subsequent majority switches. Our main contribution consists in showing how the endogenous transmission of inflation beliefs and monetary institutions in a stochastic economic environment can be understood as a process of intergenerational learning from history combined with a political economy mechanism that amends legislation and a socialization process that transmits experienced knowledge.