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Lecture 9

Lecture 9. Central Bank Independence and Conservative Central Banking. This lecture extends the analysis of reputation and credibility to the theory of central bank independence. Credibility building strategies. Credibility building measures include:

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Lecture 9

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  1. Lecture 9 Central Bank Independence and Conservative Central Banking

  2. This lecture extends the analysis of reputation and credibility to the theory of central bank independence

  3. Credibility building strategies • Credibility building measures include: • 1) Joining and exchange rate mechanism- ERM? • 2) Consistent fiscal and monetary policy - stability pact? • 3) Independent Central Bank

  4. Independent CB • This lecture will examine the third of these strategies • Staring point is a Rational Expectations Phillips curve where x is the deviation of output from equilibrium. • x = ( - e) +  • where  is inflation, e is the expected rate of inflation and  is a random shock

  5. Society’s Iso-Loss function

  6. C2 C1 C0 0 x- x

  7. Time-consistent policy is given by agents optimising

  8. But the CB/government optimises

  9. The time-inconsistency problem • The last 2 equations highlight the time-inconsistency problem • the term bx-implies that the average inflation rate is above zero • The first best policy would be to eliminate the inflation bias without eliminating the degree of output stabilisation

  10. But this is not credible

  11. The ‘Inflation Nutter’ Deflationary bias  <0 C3 A =0 C2 >0 B C1 C C’ A’ x B’

  12. Optimal set of preferences for a CB

  13. Substitute CB preference result into societies loss function

  14. Optimising with respect to 

  15. Summary • Rogoff argues that  < b - we need a conservative CB but not too conservative • The model can be criticised - why should society prefer x-> 0 when x* = 0? • Has to be argued in terms of distribution - political economy terms • Minford critique - society gets the CBs they deserve?

  16. Evidence - Inflation?

  17. Growth Variability

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