Lecture 9 Central Bank Independence and Conservative Central Banking

This lecture extends the analysis of reputation and credibility to the theory of central bank independence

Credibility building strategies Credibility building measures include: 1) Joining and exchange rate mechanism- ERM? 2) Consistent fiscal and monetary policy - stability pact? 3) Independent Central Bank

Independent CB This lecture will examine the third of these strategies Staring point is a Rational Expectations Phillips curve where x is the deviation of output from equilibrium. x = ( - e ) + where is inflation, e is the expected rate of inflation and is a random shock

Societys Iso-Loss function

x 0 C0C0 C1C1 C2C2 x-x-

Time-consistent policy is given by agents optimising

But the CB/government optimises

The time-inconsistency problem The last 2 equations highlight the time- inconsistency problem the term bx - implies that the average inflation rate is above zero The first best policy would be to eliminate the inflation bias without eliminating the degree of output stabilisation

But this is not credible

The Inflation Nutter Deflationary bias x A B C C1C1 C2C2 C3C3 >0 =0 <0 C B A

Optimal set of preferences for a CB

Substitute CB preference result into societies loss function

Optimising with respect to

Summary Rogoff argues that < b - we need a conservative CB but not too conservative The model can be criticised - why should society prefer x - > 0 when x* = 0? Has to be argued in terms of distribution - political economy terms Minford critique - society gets the CBs they deserve?

Evidence - Inflation?

Growth Variability