API-120 Prof. J.Frankel 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?

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

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.

Dynamic inconsistency: The intuition API-120 Prof. J.Frankel

π πeπe ● ● ● 2. If π e would stay at 0, then to get the higher Y it would be worth paying the price of π>0.

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

API-120 Prof. J.Frankel 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 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 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 gold2. Money growth 3. Exchange rate4. Nominal GDP 5. CPI 6. GDP deflator

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 Addressing the Time-Inconsistency Problem (continued)

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

“Central Bank Independence, Inflation and Growth in Transition Economies,” P.Loungani & N.Sheets, IFDPS (1995) for transition economies

API-120 Prof. J.Frankel Limitations to the argument for central bank independence 1.Some consider it undemocratic. 2.The argument only works if the right 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.

Five advanced countries adopt IT: Many developing countries adopt IT: Agénor & Pereira da Silva, 2013, Fig.1. "Rethinking Inflation Targeting: A Perspective from the Developing World," CGBCR DP 185, U.Manchester.. Inflation Targeting (IT)

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

by tying hands

API-120 Prof. J.Frankel Introducing disturbances into the Barro-Gordon model à 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 Appendix 1: GLOBAL INFLATION HAS DECLINED SINCE 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 peak: early 80s

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

Appendix 2: Targets & Instruments of Policymaking INDICATORS Stock market, Commodity prices, Consumer confidence, PMI … INTERMEDIATE TARGETS M1 Exchange rate Core CPI Nominal GDP OBJECTIVES Inflation Growth & Unemployment Balance of payments INSTRUMENTS Overnight interest rate Open market operations Reserve requirements Foreign exchange intervention API-120 Prof. J.Frankel

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) Appendix 3: Comparison of alternate rules (M1 vs. E vs. CPI …)

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