The Case for Central Bank Independence

What happens when the Central Bank is independent?

-Controls monetary policy -The Central Bank is now able to use inflation targetting, setting a specific rate of inflation to achieve. -Policy is credible -Short-term political incentives are prevented

What are the cons of dual mandates?

-Decreases the transparency of the monetary policy framework, where it is unclear to workers whether inflation has risen because of supply shocks or because of short-term political incentives. -Weakens the anchoring of inflation expectations

What are the costs of inflation targetting?

-Implies a narrow focus on price stability -Although aggregate demand shocks do not have an effect on output stabilization, supply shocks impose a trade-off between inflation and output stabilization. -In other words, under a supply shock, one must choose whether to lower inflation or to increase output --> both cannot happen at once

What are the benefits of inflation targetting?

-The Central Bank can control inflation without actually increasing interest rates -The credible threat of raising rates is enough to keep inflation expectations in check

Under an inflation target, what happens when there is an aggregate supply shock?

-The SRAS shifts to the left -Price is higher (inflation went up) and output fell; economy is in recession -However, because the CB has an inflation target, the CB reaches it by tightening monetary policy -Aggregate demand shifts left, economy is back at inflation target, but output has fallen even further; recession is exacerbated -Indicates the trade-off between price stabilisation and output stabilisation

What are the pros of dual mandates?

-The government can intervene in the economy when there is a recession -Allows for greater flexibility in monetary policy

What is inflation determined by?

1) Increase in aggregate demand -movement along the Phillips curve 2) Increase in inflation expectations - upwards shift of the Phillips curve

Short run equilibrium

1) Inflation expectations and wage demands remain low (first SRPC depicts low inflation expectations) 2) Government boosts aggregate demand and output through an inflation surprise 3) Unemployment falls. However, inflation expectations remain low due to adaptive expectations 4) Economy moves along the SRPC with low expected inflation

Long run equilibrium

1) Workers demand higher real wages 2) Inflation expectations increase and SRPC shifts up 3) Inflation higher, but unemployment reverts to natural rate 4) Therefore, there is no trade-off between inflation and unemployment in the long-run.

Why is a dual mandate important?

Allows for greater flexibility in trading off inflation stabilization for output & employment stabilization

Dual Mandate

An agreement between the federal government and the Central Bank to achieve both price stability and maximum employment.

Inflation Bias

Because the public realizes that the government is always tempted to inflate the economy in the long-run, inflation expectations and inflation becomes permanently higher.

Why are Conservative central bankers usually appointed?

Conservative central bankers are usually appointed because they are strongly against inflation, where it is more likely that a rise in inflation would be in response to supply shocks rather than to attain political ends.

How do political incentives affect inflation?

If politicians decide to implement monetary policy that lowers the unemployment rate in the short-run to win the re-elections, the unemployment rate would ultimately remain the same, and the inflation rate would be permanently higher in the long-run, making society worse off.

How does an increase in inflation expectations determine inflation?

If workers expect inflation in the future, they will negotiate for higher wages, which would increase the costs of labour and therefore increase inflation. As a result, the short-run Phillips curve shifts upward.

Time Inconsistency

Long-term plans are incompatible with short-term incentives

Anchoring Effect

Tying (or anchoring) inflation expectations to the inflation target rate, which prevents a permanent rise of the inflation rate in the long-run. Because of this, the Central Bank does not need to increase interest rates to control inflation.