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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.

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.

Suggested Citation

  • Buiter, Willem H., 2006. "How Robust is the New Conventional Wisdom? The Surprising Fragility of the Theoretical Foundations of Inflation Targeting and Central Bank Independence," CEPR Discussion Papers 5772, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:5772
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    References listed on IDEAS

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    Cited by:

    1. Stefan Collignon & Sebastian Diessner, 2016. "The ECB's Monetary Dialogue with the European Parliament: Efficiency and Accountability during the Euro Crisis?," Journal of Common Market Studies, Wiley Blackwell, vol. 54(6), pages 1296-1312, November.
    2. Marc Quintyn, 2009. "Independent agencies: more than a cheap copy of independent central banks?," Constitutional Political Economy, Springer, vol. 20(3), pages 267-295, September.
    3. 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.

    More about this item

    Keywords

    accountability; central bank intertemporal budget constraint; flexible inflation targeting;

    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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