Topic 2: The Case for Central Bank Independence

Tradeoff of Dual Mandate

A dual mandate can decrease transparency of the monetary policy framework: • Suppose inflation is rising, but the Fed cuts interest rates anyway: ● (i) accommodation of supply shock, or ● (ii) Fed is inflating the economy due to political pressure? • Hence a dual mandate might undermine anchoring of inflation expectations.

Rogoff's conservative central banker

A dual mandate works well in the hands of a Chairman who has a strong aversion to inflation. • If a conservative Chairman cuts interest rates and inflation rises: ● (i) accommodation of supply shock, or ● (ii) Fed is inflating the economy due to political pressure? (i) is the more likely scenario - the CB's fervent dislike of inflation means she has less temptation to inflate the economy With a conservative CB,we get the best of both worlds - ● inflation expectations remain anchored ● flexibility in policy response in the face of a severe supply shock. Conservative CB's indifference curves are flatter than a liberal policymaker because in order to increase price level, there must be a large reduction in unemployment.

Central bank independence

Central bank independence is an effective method for governments to "tie themselves to the mast". Unaffected by short run electoral incentives, the central bank's commitment to low inflation is credible.

Determinants of Inflation

Expansion of aggregate demand leads to higher inflation: -we move along the SR Phillips curve Increase in inflation expectations leads to higher inflation: -workers increase wage demands to maintain real wages -firms' labor costs increase, they push up prices and inflation increases -SR Phillips curve shifts upwards At intersection of SRPC and LRPC, inflation expectations equal actual inflation.

Time inconsistency

Governments understand that a low inflation policy is in the long term interests of society, but they cannot stick to it due to short term political incentives. (long term plans are incompatible with short term incentives.)

Costs of inflation targetting

Inflation targetting implies a narrow focus on price stability. What about output and employment stability? • Not a problem with demand shocks due to the divine coincidence - inflation and output stabilization go hand in hand. • However, with a supply shock the central bank faces a fundamental trade-off between inflation and output stabilisation. • A narrow focus on price stability exacerbates fluctuations in output and employment.

Shifting the SRPC

Shift up when high expected inflation, shift down when lower expected inflation

Government controls policy (SR)

Suppose the government controls monetary policy and faces re-election in May 2017: -Jan 2017: Inflation expectations and wage demands remain low Feb 2017: -government boosts aggregate demand and output through an inflation surprise May 2017: -unemployment falls -inflation expectations remain low (due to adaptive expectations) -government wins the election!

LR Inflation/Unemployment

There is no trade-off between inflation and unemployment in the long run.

Inflation targeting vs. Dual Mandate

inflation targetting is more like a formal rule, whereas dual mandate is a form of constrained discretion. Evaluation: Inflation targeting is more explicit, and therefore more credible. In order to eliminate this problem, the CB must have a long term contract, or, even better, be a conservative central banker. Short term appointments for the Governor are ineffective as the time inconsistency problem re-surfaces. Inflation target is an effective method of ensuring central bank accountability but without compromising credibility of the monetary policy framework.With a dual mandate, we are heavily reliant on the individual expertise and track record of the Governor. The dual mandate is more flexible than a specific inflation target - Inflation targetting implies a narrow focus on price stability, whereas dual mandate allows the CB greater flexibility in trading off inflation stabilization for output and employment stabilisation. If a regime sets a flexible inflation spread instead of a direct target, this helps increase flexibility. The Dual Mandate fails to be transparent. The dual mandate essentially boils down to a "Taylor Rule", or what King (1997) refers to as an "optimal state-contingent rule" in which the CB sets monetary policy in order to minimize deviations of output and inflation from some implicit target levels according to its relative preferences. But the public don't know what the rule is and even if they did it is difficult to verify whether the CB is actually following it, hence the time inconsistency problem might re-appear. However, this is mitigated by appointing a conservative central banker.

Inflation bias

the public realizes that the government is always tempted to inflate the economy, so inflation expectations and inflation itself are permanently higher.

Benefits of inflation targetting

• An explicit and transparent inflation target helps to "anchor" inflation expectations. • A temporary increase in inflation does not become a permanent increase in inflation, because inflation expectations are tethered to the inflation target. • The anchoring effect means the central bank can control inflation without actually increasing interest rates!

Summary

• Government control of monetary policy leads to permanently high inflation due to the problem of time inconsistency. • Central bank independence eliminates this problem and delivers low inflation. • An explicit inflation target boosts credibility of the monetary policy framework and helps to anchor inflation expectations, but suffers from inflexibility. • A dual mandate can achieve the best of both worlds, if in the hands of a conservative central banker.

Policy credibility

• Government policies are often designed to shape the public's expectations. • But they are not credible in the long run: once served their purpose, the policies are dumped.

Late 1980s/early 1990s

• Monetarism abandoned • Lawson boom • Inflation surged to 10%

Inflation targetting

• Price stability has emerged as the dominant mandate for central banks across the world: ● about 27 countries now operate fully- fledged inflation-targetting regimes • Thus, the debate about central bank independence is intrinsically linked to the debate about inflation targetting.

1979 Thatcher Government

• Thatcher govt. key priority - low inflation • Monetarism: controlling money supply growth • "Inflation is always and everywhere a monetary phenomenon" (Milton Friedman) • Interest rates hit 17% • Inflation fell below 5%.

Dual mandate

• The US Federal Reserve has a dual mandate to achieve both price stability and maximum employment. • This allows greater flexibility in trading off inflation stabilization for output & employment stabilization.