The Welfare State as a Substitute for a Conservative Central Banker

Abstract

Many years since their introduction, positive theories of inflation have rarely been tested. This paper documents a negative relationship between inflation and the welfare state (proxied by the parameters of the unemployment benefit program) that is to be expected in such theories. Because unemployment benefits make the monetary authority less concerned about the plight of the unemployed, building a welfare state has a similar effect to appointing a conservative central banker. The relationship holds in a panel of 21 OECD countries over the period 1961-92, a region where Romer (1993) finds no evidence of commitment problems. It also holds controlling for country and time fixed effects, country specific time trends, other co-variates and a lagged dependent variable. The effects are economically large: a one standard deviation decrease in benefits is predicted to add 2.7 percentage points to inflation, or 52 percent of the standard deviation in inflation. We also allow for unemployment benefits to be endogenously determined.

Keywords: Inflation, unemployment benefits, endogenous welfare state

JEL Classification: E52, E62, F41