LECTURE 6: DYNAMIC INCONSISTENCY OF MONETARY POLICY, AND HOW TO ADDRESS IT

1. LECTURE 6:DYNAMIC INCONSISTENCY OF MONETARY POLICY, AND HOW TO ADDRESS IT • Question: Why is inflation, π, often high?Why π > 0 more often than π < 0? • One of several answers:Proclamations of low-inflation monetary policy by central banks are “dynamically inconsistent.” • Next question:What institutions can address dynamic inconsistency? API-120 Prof. J.Frankel

2. Inflation is usually > 0and was a chronic problem during 1950-2000. Source: Carmen Reinhart & Ken Rogoff, This Time is Different: A Panoramic View of Eight Centuries of Financial Crises. API-120 Prof. J.Frankel

3. If monetary expansion can’t reduce unemploymentin the long run, why is inflation so common? Four possible explanations: • Governments think expansion can reduce unemployment in the long run. • They give low weight to price stability, or have high discount rates (e.g., political business cycle). • Plans to set non-inflationary monetary policy are perceived by the public to be time-inconsistent. • Governments want seignorage, to pay for spending that is not financed by taxes or borrowing. API-120 Prof. J.Frankel

4. Dynamic inconsistency: The intuition • Assume governments, if operating under discretion, choose monetary policy and hence AD so as to maximize a social function of Y&π. • => Economy is at tangency of AS curve &one of the social function’s indifference curves. • Assume also that the social function centers on > , even though this point is unattainable, at least in the long run. • Assume W & P setters have rational expectations. • => πe (& AS) shifts up if rationally-expected E π shifts up. • => πe = E π = π on average. • economy is at point B on average. Inflationary bias: πe = E π > 0. • Lesson: The authorities can’t raise Y anyway, so they might as well concentrate on price stability at point C. API-120 Prof. J.Frankel

5. 3. But πe adjusts upward in responseto observed π>0. The LR or Rational Expectations equilibrium must feature πe = π. Result: inflationary bias π>0, despite failure to raise Y above . 2. If πe would stay at 0, π then to get the higher Y it would beworth payingthe price of π>0. πe ● ● 4. The country would be better off “tying the hands” of the central bank. Result: π=0. And yet Y =(no worse than average under discretion). • ● • Barro-Gordon innovation: It is useful to think of society’s 1st choice as Y= • (& π=0), even if it is unattainable. API-120 Prof. J.Frankel

6. Time-Inconsistency of Non-Inflationary Monetary Policy (Romer 11.53) + Policy-maker minimizes quadratic loss function: where the target. => (11.54) API-120 Prof. J.Frankel

7. Given discretion, the CB chooses the rate of money growth and inflation (assuming it can hit it) where . Take the mathematical expectation: + Rational expectations: => (10.15), the inflationary bias. (11.58) API-120 Prof. J.Frankel

8. ADDRESSING THE TIME-INCONSISTENCY PROBLEM • How can the CB credibly commit to a low-inflation monetary policy? • Announcing a target π = 0 is time-inconsistent, because a CB with discretion will inflate ex post, and everyone knows this ex ante. • CB can eliminate inflationary bias only by establishing non-inflationary credibility, • which requires abandoning the option of discretion. • so public will see the CB can’t inflate even if it wants to. • CB “ties its hands,” as Odysseus did in the Greek myth. API-120 Prof. J.Frankel

9. Addressing the Time-Inconsistency Problem (continued) • Reputation • Delegation. Rogoff (1985):Appoint a CB with high weight on low inflation a′ >> a , and grant it independence.It will expand at only << inflationary bias of discretion. • Binding rules.Commit to rule for a nominal anchor: 1. Price of gold 2. Money growth3. Exchange rate 4. Nominal GDP 5. CPI 6. GDP deflator API-120 Prof. J.Frankel

10. Addressing the Time-Inconsistency Problem (continued) • Reputations. With multiple periods, a CB can act tougher in early periods, to build a reputation for monetary discipline. • Backus-Driffill(1985) model: people are uncertain if the CB is of hard-money or soft-money “type.” • Then even a soft CB may act tougher, to influence subsequent expectations. API-120 Prof. J.Frankel

11. Delegation Alesina & Summers: Central banks that are institutionally independent of their governments have lower inflation rates on average. API-120 Prof. J.Frankel

12. for transition economies “Central Bank Independence, Inflation and Growth in Transition Economies,”P.Loungani & N.Sheets, IFDPS95-519  (1995) API-120 Prof. J.Frankel

13. Limitations to the argument for central bank independence Some consider it undemocratic. The argument only works if the right central bankers are chosen. Although independence measures are inversely correlated with inflation, these measures have been debated and, more importantly, the choice to grant independence could be the result of priority on reducing inflation. As with rules to address time-inconsistency, there is little empirical evidence that it succeeds in reducing inflation without loss of output. As with rules, one loses ability to respond to SR shocks. API-120 Prof. J.Frankel

14. Inflation Targeting (IT) Many developing countries adopt IT:1999-2008 Five advanced countries adopt IT:1990-93 Agénor&PereiradaSilva, 2013, Fig.1. "Rethinking Inflation Targeting: A Perspective from the Developing World," CGBCR DP 185, U.Manchester. .

15. Countries adopting IT experienced lower inflationGonçalves & Salles, 2008, “Inflation Targeting in Emerging Economies…” JDE API-120 Prof. J.Frankel

16. by tying hands

17. Introducing disturbances into the Barro-Gordon modelà la Rogoff (1985) and Fischer (1987) AS shocks No effect on inflation bias. Average inflation = Shocks will show up as fluctuations in actual  & y. But discretionary monetary policy can’t offset AS shocks anyway (can only choose the split  vs. y). => Strong case for committing to E=0. AD shocks Again no effect on inflation bias. Need not show up as fluctuations in actual  & y : If lags in monetary policy < lags in adjustment of W & P, under discretion CB can offset AD shocks. => Choice of rules vs. discretion then becomes choice of eliminating LR inflation bias (E=0) vs. SR shocks. API-120 Prof. J.Frankel

18. Appendix 1: GLOBAL INFLATION HAS DECLINED SINCE 1990. WHY? • Better understanding of costs of inflation and the temporariness of the AS tradeoff ? • Spread of commitment devices such as central bank independence, hard exchange rate pegs (currency boards & monetary unions), & IT? • Rogoff (2003): Globalization & increased competition have reduced  and/or and thereby the inflationary bias . API-120 Prof. J.Frankel

19. peak: early 80s API-120 Prof. J.Frankel

20. Continued from previous peak: ≈ 1990 peak: early 90s API-120 Prof. J.Frankel

21. Appendix 2: Targets & Instruments of Policymaking API-120 Prof. J.Frankel

22. Appendix 3: Comparison of alternate rules (M1 vs. E vs. CPI…) The choice of anchor depends on: • Credibility of the commitment • Tradeoff: advantage of time-consistent commitment vs. ability to stabilize short-term shocks • Must compare E(Loss) function for M vs. GDP vs. ex.rate vs. P targets) • Original treatment due to Rogoff (1985) • Other objectives served (e.g., a peg cuts exchange rate risk) API-120 Prof. J.Frankel

23. 6 proposed nominal targets and the Achilles heel of each: API-120 Prof. J.Frankel