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

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  • Florin O. Bilbie

Abstract

This paper argues that delegation (optimal institutional design) is not a solution to the dynamic inconsistency 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.nuff.ox.ac.uk/economics/papers/2005/w10/Deus-ex-machina.pdf
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Paper provided by University of Oxford, Department of Economics in its series Economics Series Working Papers with number 2005-W10.

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Date of creation: 01 Mar 2005
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Handle: RePEc:oxf:wpaper:2005-w10

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  1. Michael Woodford, 1999. "Optimal monetary policy inertia," Proceedings, Federal Reserve Bank of San Francisco.
  2. 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.
  3. 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.
  4. Richard Clarida & Jordi Galí & Mark Gertler, 1997. "The science of monetary policy: A new Keynesian perspective," Economics Working Papers 356, Department of Economics and Business, Universitat Pompeu Fabra, revised Apr 1999.
  5. 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.
  6. Lockwood, B. & Miller, M. & Zhang, L., 1994. "Designing Monetary Policy when Unemployment Persists," Discussion Papers 9408, Exeter University, Department of Economics.
  7. Barro, Robert J. & Gordon, David B., 1983. "Rules, discretion and reputation in a model of monetary policy," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 101-121.
  8. Robert J. Barro & David B. Gordon, 1981. "A Positive Theory of Monetary Policy in a Natural-Rate Model," NBER Working Papers 0807, National Bureau of Economic Research, Inc.
  9. Jensen, Henrik, 1997. "Credibility of Optimal Monetary Delegation," American Economic Review, American Economic Association, vol. 87(5), pages 911-20, December.
  10. Walsh, Carl E, 1995. "Optimal Contracts for Central Bankers," American Economic Review, American Economic Association, vol. 85(1), pages 150-67, March.
  11. 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.
  12. 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.
  13. 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.
  14. Stokey, Nancy L, 1989. "Reputation and Time Consistency," American Economic Review, American Economic Association, vol. 79(2), pages 134-39, May.
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