Central banks and ambiguity

In referring to the ‘animal spirits’ of investors, Keynes had already pointed to a basic distinction between ‘calculable’ and ‘non-calculable’ risk or ‘ambiguity’. The purpose of this paper is to discuss the effects of ambiguity on the public’s expectations about inflation and the impact this may have on central bank policy. We consider the case where ambiguity is caused by a lack of predictability in monetary policy. The effects of this loss of predictability are addressed in the setting of a Barro and Gordon - type framework, featuring a short run aggregate supply curve. Within this framework we distinguish between ‘strategic ambiguity’ faced by the public sector and ‘state ambiguity’ faced by the central bank. The main results are as follows. Ambiguity about monetary policy can be characterised as a loss of central bank credibility. When the public is pessimistically inclined, its consequences are excessive expectations of inflation and a national income below its natural rate. This result is obtained both in the context of ‘rules’ and of ‘discretion’, although the impact of ambiguity is more pronounced in the latter case. If the public is optimistic with respect to the monetary policy of the central bank, a lack of predictability has no impact on the inflation expectations of the public. The expected rate of inflation is the same as in the absence of ambiguity. The results are illustrated by considering the effect of initial ambiguity about the European Central Bank, the efforts of the central banks of the EU-accession countries to establish credibility, and the impact of EU-accession on the predictability of their monetary policies. A final illustration is the potential impact of a glorification of the Federal Reserve and its chairman, Alan Greenspan.