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How Robust is the New Conventional Wisdom? The Surprising Fragility of the Theoretical Foundations of Inflation Targeting and Central Bank Independence

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Buiter, Willem H

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Abstract

Flexible inflation targeting cannot be rationalised using conventional welfare economic criteria, except in a single, practically uninteresting special case. New-Keynesian DSGE models imply that optimal monetary policy implements the Bailey-Friedman Optimal Quantity of Money rule and that actual inflation fully validates or accommodates core inflation. Flexible inflation targeting is also inconsistent with the mandates of leading inflation targeters like the Bank of England and the ECB. These mandates are lexicographic in price stability and therefore does not permit a trade-off between inflation volatility and output gap volatility in the monetary policy maker's objective function. Operational independence of the central bank is limited by the central bank's intertemporal budget constraint. Price stability, or an externally imposed inflation target, may not be independently financeable by the central bank. In that case, active budgetary support from the Treasury is necessary to make the inflation target financeable. Independent monetary policy is fully compatible with coordinated and cooperative monetary and fiscal policy. Central bank operational independence precludes substantive accountability; it is compatible only with a weak form of formal accountability: reporting obligations. Central bank independence will only survive if it is viewed as legitimate by the polity and its citizens. A necessary condition for this is that the central bank restricts its activities and public discourse to its natural core mandate: price stability and the capacity and willingness to act as lender of last resort. The Protocol on the Statute of the ESCB and the ECB has given the ECB a mandate that goes beyond this natural core mandate. Such behaviour represents a threat to its continued independence.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 5772.

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Date of creation: Jul 2006
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Handle: RePEc:cpr:ceprdp:5772

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Related research
Keywords: accountability; central bank intertemporal budget constraint; flexible inflation targeting;

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Find related papers by JEL classification:
D6 - Microeconomics - - Welfare Economics
E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles
E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
H0 - Public Economics - - General

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  1. Alberto Locarno, 2007. "Imperfect Knowledge, Adaptive Learning, and the Bias Against Activist Monetary Policies," International Journal of Central Banking, International Journal of Central Banking, vol. 3(3), pages 47-85, September. [Downloadable!]
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