Testing Commitment Models of Monetary Policy: Evidence from OECD Economies

Inflation rates in a number of OECD follow a common trend over the past four decades: inflation starts out low in the 1960s, rises for a time before peaking in the 1970s or early 1980s, and then falls back to initial levels. This similarity in the behavior of trend inflation suggests that any explanation of long run inflation trends ought to apply across OECD countries. Ireland (1999) shows that a simple time inconsistency model of monetary policy, modified to allow for a time-varying NAIRU, can explain long run trends in U.S. inflation. In this paper we show that this result cannot serve as an explanation of the common trend in OECD inflation, as it fits the data only in the U.S.. We investigate two important variants of the hypothesis: i) that time inconsistency was an important component of central bank behavior in earlier decades, but has become less significant in recent years, and ii) that time inconsistency problems drive U.S. inflation, which affects inflation rates in other countries as a result of central bankers' attempts to manage nominal exchange rate movements vis a vis the U.S. dollar. We find that the first hypothesis fits the data no better than the baseline model. We find some support for the international spillovers version of the model, but the behavior of non-U.S. central bankers with respect to domestic unemployment rates is not well described by the time inconsistency mechanism.