Rational Expectations and Policy Credibility Following a Change in Regime

We examine the dynamic path of an economy after a change in regime, when neither the policy to be followed nor the reactions of the public are known. The model is an application of Kreps and Wilson's reputation model to Barro and Gordon's macroeconomic policy game. Equilibrium is defined to be the dynamically consistent solution to a game between the government and the private sector. It involves mixed strategies and Bayesian learning by both sides until the uncertainty about government and public behaviour is resolved. The absence of complete credibility of government policy and intransigence of private sector wage demands increase the output loss of disinflation. The analysis also sheds light on the strategic nature of economic policymaking and the role of information in macroeconomics.