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Deus ex machina wanted: time inconsistency of time consistency solutions in monetary policy

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This paper argues that delegation (optimal institutional design) is not a solution to the dynamic inconcistency problem, and can even reinforce it. We show that 'optimal' delegation is not consistent with government's incentives. We solve for delegation schemes that are consistent with these incentives and find that they imply 'no delegation'. Introducing a cost of reappointing the central banker just postpones the problem, and can only solve it if the government is infinitely averse to changing central bank's contract. Our results hint to: (i) alternative explanations for good anti-inflationary performance; (ii) strengthening central bank independence and (iii) giving a more prominent role to Central Bank reputation building in fighting inflation.

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File URL: http://www.nuffield.ox.ac.uk/economics/papers/2005/w10/Deus-ex-machina.pdf
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Paper provided by Economics Group, Nuffield College, University of Oxford in its series Economics Papers with number 2005-W10.

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Length: 16 pages
Date of creation: 10 Mar 2005
Date of revision:
Handle: RePEc:nuf:econwp:0510

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Web page: http://www.nuff.ox.ac.uk/economics/

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  1. Michael Woodford, 1999. "Optimal Monetary Policy Inertia," NBER Working Papers 7261, National Bureau of Economic Research, Inc.
  2. Persson, Torsten & Tabellini, Guido, 1993. "Designing institutions for monetary stability," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 53-84, December.
  3. Lockwood, B. & Miller, M. & Zhang, L., 1994. "Designing Monetary Policy when Unemployment Persists," Discussion Papers 9408, Exeter University, Department of Economics.
  4. Lockwood, Ben, 1997. "State-Contingent Inflation Contracts and Unemployment Persistence," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 29(3), pages 286-99, August.
  5. Robert J. Barro & David B. Gordon, 1984. "Rules, Discretion and Reputation in a Model of Monetary Policy," NBER Working Papers 1079, National Bureau of Economic Research, Inc.
  6. Stokey, Nancy L, 1989. "Reputation and Time Consistency," American Economic Review, American Economic Association, vol. 79(2), pages 134-39, May.
  7. Guy Debelle & Stanley Fischer, 1994. "How independent should a central bank be?," Working Papers in Applied Economic Theory 94-05, Federal Reserve Bank of San Francisco.
  8. Mark Gertler & Jordi Gali & Richard Clarida, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December.
  9. Jensen, Henrik, 1997. "Credibility of Optimal Monetary Delegation," American Economic Review, American Economic Association, vol. 87(5), pages 911-20, December.
  10. Lockwood, Ben & Philippopoulos, Apostolis, 1994. "Insider Power, Unemployment Dynamics and Multiple Inflation Equilibria," Economica, London School of Economics and Political Science, vol. 61(241), pages 59-77, February.
  11. Barro, Robert J & Gordon, David B, 1983. "A Positive Theory of Monetary Policy in a Natural Rate Model," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 589-610, August.
  12. Walsh, Carl E, 1995. "Optimal Contracts for Central Bankers," American Economic Review, American Economic Association, vol. 85(1), pages 150-67, March.
  13. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
  14. Henrik Jensen & Roel M. W. J. Beetsma, 1999. "Optimal Inflation Targets, "Conservative" Central Banks, and Linear Inflation Contracts: Comment," American Economic Review, American Economic Association, vol. 89(1), pages 342-347, March.
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