Transcript Dynamic inconsistency and rules

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?
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
If monetary expansion can’t reduce unemployment
in 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.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
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.
– (1) Assume also that the social function centers on Yˆ > Y ,
even though this point is unattainable, at least in the long run.
– (2) => Economy is at tangency of AS curve &
one of society’s indifference curves.
• (3) 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.
• (4) Lesson: The authorities can’t raise Y anyway,
so they might as well concentrate on price stability at point C.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
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Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
.
3. But πe adjusts
upward in response
to observed π>0.
The LR or Rational
Expectations
equilibrium must
feature πe = π.
π
πe
●
Result: inflationary
bias π>0, despite
failure to raise Y
above Y .
4. The country
would be better off
“tying the hands”
of the central bank.
Result: Y = Y
(no worse on average
2. If πe would stay
at 0,
then to get the
higher Y
it would be
worth paying the price
of π>0.
●
●
Yˆ
than under discretion),
and yet π=0.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
1. Barro-Gordon
innovation:
It can be useful to
think of society’s
1st choice as Y= Yˆ
(& π=0), even if it
is unattainable.
TIME-INCONSISTENCY
OF NON-INFLATIONARY MONETARY POLICY
y  y   (   )
e
(Romer 11.53)
+ Policy-maker minimizes quadratic loss function:
(11.54)
1
1
2
2
  ( y  yˆ )  a( )
2
2
where the target
yˆ  y .
1
1
e
2
2
ˆ
=>   ( y   (   )  y )  a( )
2
2
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Given discretion, the CB chooses the rate of money growth
and inflation (assuming it can hit it) where
d
e
 ( y   (   )  yˆ )  a ( )  0
d
Take the mathematical expectation:
( y  E (   )  yˆ )  aE ( )  0.
e
+ Rational expectations:
(10.15)
(11.58)
E 

Copyright 2007 Jeffrey Frankel, unless otherwise noted
a
  E
e
( yˆ  y )  0 ,
=>
the inflationary bias.
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Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
.
ADDRESSING THE TIMEINCONSISTENCY PROBLEM

How can the CB credibly commit
to a low-inflation monetary policy?

Announcing a policy 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.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
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Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
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    ( yˆ  y )
a
<< inflationary bias of discretion.
 Binding rules. Commit to rule for a nominal anchor:
1. Price of gold
3. Exchange rate
5. CPI
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2. Money growth
4. Nominal GDP
6. GDP deflator
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4.
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 is likely to act tougher,
to influence subsequent expectations.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
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Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
• Delegation
Alesina & Summers: Central banks
that are institutionally independent
of their governments have lower
inflation rates on average.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
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Transition
economies
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“Central Bank Independence, Inflation and Growth in Transition Economies,”
P.Loungani & N.Sheets, IFDPS95-519 (1995)
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Limitations to the Argument
for Central Bank Independence
1. Some consider it undemocratic.
2. The argument only works if
conservative central bankers are chosen.
3. Although independence measures are inversely correlated
with inflation, these measures have been debated and,
4. more importantly, the choice to grant independence could be
the result of priority on reducing inflation.
5. As with rules to address time-inconsistency,
there is little empirical evidence that it succeeds
in reducing inflation without loss of output.
6. As with rules, one loses ability to respond to SR shocks.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Inflation Targeting
After 1998, many middle-sized
middle-income countries
adopted inflation targeting.
Source: IMF Survey. October 23, 2000. Andrea Schaechter, Mark Stone, Mark Zelmer in the IMF, Monetary and Exchange Affairs Dept. Online at:
http://www.imf.org/external/pubs/ft/survey/2000/102300.pdf
The background papers for the high-level seminar “Implementing Inflation Targets,”
held -inMacroeconomic
Washington inPolicy
March
2000, Iare available on the IMF Website:
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Analysis
http://www.imf.org/external/pubs/ft/seminar/2000/targets/index.htm
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Copyright
2007 Jeffrey Frankel, unless otherwise noted
Countries adopting IT experienced lower inflation
Gonçalves & Salles, 2008, “Inflation Targeting in Emerging Economies…” JDE
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Introducing disturbances into the Barro-Gordon model
à la Rogoff (1985), Fischer (1987), et al
AS shocks
No effect on inflation bias. Average inflation =
E 

a
( yˆ  y )
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.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
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 ( yˆ  y )

and thereby the inflationary bias
( yˆ  y ) ?
a
Copyright 2007 Jeffrey Frankel, unless otherwise noted
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Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
peak:
early 80s
Copyright 2007 Jeffrey Frankel, unless otherwise noted
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Continued from
previous
peak:
≈ 1990
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peak:
early 90s
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Inflation was much more of a chronic problem
in the 20th century than in preceding centuries
Source: Carmen Reinhart & Ken Rogoff, “This Time is Different:
A Panoramic View of Eight Centuries of Financial Crises,” draft, April 2008
Appendix 2: Targets & Instruments of Policymaking
OBJECTIVES
Inflation, Price Stability
Unemployment, Growth
INSTRUMENTS
Open market operations
Foreign exchange intervention
Reserve requirements
“Policy interest rate” (short-term i)
INTERMEDIATE
TARGETS
M1
Exchange rate
Core CPI…
Index of Leading Indicators
Financial Conditions Index (incl. spreads, P/E,...)
Length of work-week
Consumer Confidence, Business Confidence
Purchasing Managers’ Index (ISM, IFO, Tankan,…)
INDICATORS
…
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Appendix 3: Comparison of alternate rules
(M1 vs. E vs. CPI …)
The choice of anchor depends on:
1. Credibility of the commitment
2. 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)
3. Other objectives served (e.g., a peg cuts exchange rate risk)
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
6 proposed nominal targets and the Achilles heel of each:
Monetarist
rule
Inflation
targeting
Nominal GDP
targeting
Gold
standard
Commodity
standard
Fixed
exchange rate
Copyright 2007 Jeffrey Frankel, unless otherwise noted
Targeted
variable
Vulnerability
Example
M1
Velocity shocks
US 1982
CPI
Import price
shocks
Oil shocks of
1973-80, 2000-08
Nominal
GDP
Measurement
problems
Vagaries of
Price
world gold
of gold
market
Price of agr.
Shocks in
& mineral
imported
basket
commodity
$
Appreciation of $
(or euro)
(or other)
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Less developed
countries
1849 boom;
1873-96 bust
Oil shocks of
1973-80, 2000-08
1995-2001