Policy credibility and the design of central banks
In recent years several countries have granted greater independence to their central banks; others have made price stability the only objective of monetary policy. These two trends can be seen as social responses to a fundamental problem of central bank credibility called the time inconsistency of monetary policy. The theory and some empirical aspects of time inconsistency are the subject of this article. ; The theory emphasizes that expected and actual inflation will be larger if a central bank cannot credibly commit to honor commitments to keep inflation low than if it can. To ameliorate this "inflation bias," institutions such as central bank independence and price stability rules may emerge. These institutional reforms may be unnecessary, however, when a central bank develops an anti-inflationary reputation over time. ; The empirical evidence reviewed in this article does not provide strong confirmation of the hypothesis that central bank independence lowers inflation. The results may reflect that reputation has played a role in ameliorating time inconsistency or that the degree of central bank independence is determined by reasons other than eliminating inflation bias.
Volume (Year): (1998)
Issue (Month): Q 1 ()
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- 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.
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