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Credibility of optimal monetary delegation: do we really need prohibitive reappointment costs?

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  • Rotondi, Zeno
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    Abstract

    The paper examines the current debate on the real effectiveness of delegation in overcoming the problem of time inconsistency that afflicts discretionary monetary policy. An important contribution by Jensen has shown that, when the government is unable to credibly carry out optimal policy and delegates monetary policy to a central banker with an announced incentive scheme, optimal policy can be credible only if reappointment costs are prohibitive. This finding is questioned in the present analysis. In particular we show that, when delegation is not considered as an alternative, but rather as supplementary, to reputation and is conducive to reputation building for the central banker, the circumstances under which optimal delegation can be credible need not be so extreme. This different result is based on the constraint that the central banker's reputation for low inflation imposes on the government's temptation to deviate from its announcements and on the role played by incentive schemes in strengthening the central banker's reputation. Keywords; delegation, reappointment, in‡ationary bias

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    Bibliographic Info

    Paper provided by Economics Division, School of Social Sciences, University of Southampton in its series Discussion Paper Series In Economics And Econometrics with number 0003.

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    Date of creation: 01 Jan 2000
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    Handle: RePEc:stn:sotoec:0003

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    1. Robert J. Barro & David B. Gordon, 1983. "Rules, Discretion and Reputation in a Model of Monetary Policy," NBER Working Papers 1079, National Bureau of Economic Research, Inc.
    2. 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, University of Chicago Press, vol. 91(4), pages 589-610, August.
    3. Herrendorf, Berthold, 1998. "Inflation Targeting as a Way of Precommitment," Oxford Economic Papers, Oxford University Press, vol. 50(3), pages 431-48, July.
    4. Bennett T. McCallum, 1996. "Crucial Issues Concerning Central Bank Independence," NBER Working Papers 5597, National Bureau of Economic Research, Inc.
    5. Svensson, Lars E O, 1997. "Optimal Inflation Targets, "Conservative" Central Banks, and Linear Inflation Contracts," American Economic Review, American Economic Association, American Economic Association, vol. 87(1), pages 98-114, March.
    6. McCallum, Bennett T, 1995. "Two Fallacies Concerning Central-Bank Independence," American Economic Review, American Economic Association, American Economic Association, vol. 85(2), pages 207-11, May.
    7. Miller, M., 1997. "Eurosclerosis, Eurochicken and the Outlook for EMU," The Warwick Economics Research Paper Series (TWERPS), University of Warwick, Department of Economics 482, University of Warwick, Department of Economics.
    8. Backus, David & Driffill, John, 1985. "Inflation and Reputation," American Economic Review, American Economic Association, American Economic Association, vol. 75(3), pages 530-38, June.
    9. Robert J. Barro, 1986. "Reputation in a Model of Monetary Policy with Incomplete Information," NBER Working Papers 1794, National Bureau of Economic Research, Inc.
    10. Persson, Torsten & Tabellini, Guido, 1993. "Designing institutions for monetary stability," Carnegie-Rochester Conference Series on Public Policy, Elsevier, Elsevier, vol. 39(1), pages 53-84, December.
    11. Jensen, Henrik, 1997. "Credibility of Optimal Monetary Delegation," American Economic Review, American Economic Association, American Economic Association, vol. 87(5), pages 911-20, December.
    12. Al-Nowaihi, A & Levine, Paul L, 1996. "Independent but Accountable: Walsh Contracts and the Credibility Problem," CEPR Discussion Papers, C.E.P.R. Discussion Papers 1387, C.E.P.R. Discussion Papers.
    13. Adam S. Posen, 1995. "Declarations Are Not Enough: Financial Sector Sources of Central Bank Independence," NBER Chapters, National Bureau of Economic Research, Inc, in: NBER Macroeconomics Annual 1995, Volume 10, pages 253-274 National Bureau of Economic Research, Inc.
    14. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 85(3), pages 473-91, June.
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