The central bank stabilizes the economy by adjusting inflation so that unemployment shocks are partly offset. In a rational-expectations equilibrium, the bank chooses the inflation rate so that the marginal gain from lower unemployment is exactly balanced by the marginal loss of higher inflation. The inflation bias is increasing in equilibrium unemployment, because higher equilibrium unemployment means a larger marginal gain of unemployment reductions through unanticipated inflation; the responsiveness of unemployment to unanticipated inflation, because a higher responsiveness means that a given unemployment reduction can be achieved at a lower cost in terms of unanticipated inflation; and the unemployment-aversion parameter, because a higher aversion to unemployment means that a given unemployment reduction is valued more highly. 7 pgs. Bibliography lists 16 sources.
