EC321 Monetary Economics

Topic 4 Rules v discretion: central bank

independence and inflation targets
Charlie Bean
Lent Term 2015

Todays themes
1. In todays lecture, we shall see the presence of distortions
may lead to a time inconsistency problem in policy.
This time inconsistency problem leads to an upward bias
in inflation and an argument for rules rather discretion.
2. We shall look at solutions to this inflation bias, including:
Reputation;
Appointment of conservative central bankers;
Inflation targeting;
CB independence.

Ec321 Monetary Economics Lent term Topic 4

Time inconsistency
A policy is time consistent if an action planned at date for
+ remains optimal to implement when + arrives.
A policy is time inconsistent if at + it is NOT optimal to
implement the policy as originally planned, even though the
environment has not changed.
A first-best monetary policy may be time inconsistent.
Moreover, private-sector expectations of future monetary
policy settings affect outcomes today.
The interaction of the above is important for both the
positive and normative analysis of monetary policy:
Positive policymakers incentives may lead to an
upward bias to inflation;
Normative it influences the design of the institutional
framework for the conduct of monetary policy.
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The inflation bias: Optimal monetary policy under discretion

We employ a version of the model of Topic 3, but with > 0.
Loss Function: = 12 [2 + ( )2]
NKPC:

= +1 + +

IS:

= +1 +1 / +

To keep the algebra simple, put = 1 and = = 0.

As before, policymaker treats +1 as given; problem is:

12 [2 + ( )2] subject to: = +1 +

The first-order condition is:
. + ( ) = 0 with =

Hence:

=
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Private-sector expectations and equilibrium

Private agents understand that in each period the policymaker aims for:
=
Remember when = 0, this gave = = 0 in equilibrium.
Conjecture: and are constant at all times; it then follows that
[+1 ] = . Hence the FOC and the Phillips curve are:
= and = +
From Phillips curve, = 0. Then from FOC:
= > 0
Finally, the IS equation gives:
= +
Hence the nominal interest rate is also higher by (the real
interest rate is unaffected).
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Graphical analysis: Inflation bias

PC (with +1 = )

PC (with +1 = 0)

FOC: = ( )

B
A
O

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Inflation bias: intuition

Equilibrium: = 0 and = > 0 when > 0.
At = 0 (point O), policymaker not content with = 0 (natural
output, , too low); tries to push beyond by loosening
policy (point A).
Private agents understand policymakers incentives +1 .
Equilibrium is where Phillips curve is tangent to indifference
ellipse and output is at its natural rate ( = 0; point B).
At this point, the policymaker has no incentive to deviate: inflation
has to be high enough to discourage policymaker from expanding
output beyond .
The inflation bias is larger, the more the policymaker cares about
output (i.e. the higher is ).
Note that this is not the consequence of the policymaker failing to
understand the results of his actions; rather it is the consequence
of being unable credibly to commit (tie ones hands).
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The Great Inflation in the UK: The bias in action?

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The Great Inflation

The model provides one rationalisation for the take-off of
inflation in the mid-70s (the Great Inflation).
rose (union power increased).
Government treated inflation expectations as given and
tried to maintain output above its natural rate.
As a result, inflation expectations increased.
This led to higher inflation, which the Government tried to
restrain through incomes policies (effectively raises natural
rate of output).
These were only effective temporarily: ultimately had higher
inflation with no gain in activity (unemployment rose).
But there were other factors at work too, e.g. oil prices
quadrupled in 1973 after Yom Kippur war.
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Normative analysis
The model is useful because it makes us think seriously
about the incentives facing the policymaker and the role of
expectations. Two themes:
Should policy be left to the policymakers discretion or
should it be conducted subject to constraints (rules)?
Can we design the institutions of monetary policy to achieve
better outcomes?
Central bank independence;
Appointment of a conservative central banker;
Inflation targeting.

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Rules v Discretion
We would like to eliminate the wasteful inflation bias.
One way is by requiring the policymaker to keep inflation at
zero, e.g. by hardwiring it into the constitution; this is
referred to as a commitment mechanism.
Provided such a mechanism is credible, it solves the problem
in the simple set-up considered above.
However, such simple rules potentially constrain the
policymaker from responding optimally to shocks.

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Rules v Discretion: Discretion with cost shocks

With 0, the FOC for optimal policy is still:
=
= { +1 + + }

The associated equilibrium becomes (proof as an exercise):

= [/(2 + )]
= + 2 +
NB: This is just the discretionary equilibrium from earlier
plus the optimal stabilisation term of Slide 24, Topic 3.

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Rules v Discretion: Welfare under discretion

The equilibrium is:
= [/(2 + )] and = + 2 +
The expected loss is then (remember = 2 ):

[ ] = 12 [2 + ( )2]
1
=
2

1
=
2

+ 2
+

2 +
2

+ 2
+

+ 2
2
+

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Rules v Discretion: Welfare under a rule

Under a zero-inflation-at-all times rule, from the Phillips
curve we have:
= / with = +1 = 0

The associated expected loss is then:

[ ] = 12 [2 + ( )2]
1
2
2

= + 2
2

Hence the rule is better than discretion if and only if:

2

<
2

+ 2
2
+

2 < (2 +) 2
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Rules v Discretion: Discussion

We would like to be able to make the policymaker follow the
rule: = [/(2 + )] . This is the first-best rule.
This gives an optimal response to shocks and is not subject
to an inflation bias. It is time inconsistent, however, and thus
incredible without a viable commitment mechanism.
Legislation may work for a simple rule (e.g. zero inflation at
all times) but not for a complex feedback rule (especially if
the shock is private information to the policymaker).
Can we think of institutional arrangements that might help
to mitigate the inflation bias problem and yet permit
stabilisation in response to cost shocks?

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Overcoming the inflation bias: Reputation and delegation

The inflation bias arises because the policymaker treats
inflation expectations as given.
If (s)he takes account of the impact of current actions on
expectations, then (s)he can sustain a low inflation equilibrium.
In essence, the policymaker foregoes the short-run gain from
stimulating the economy in order to build a reputation for
sticking to a low inflation policy.
For this to work, the policymaker needs to have a long horizon.
Politicians are prisoners of short-term electoral pressures and
so will find it difficult to build and maintain such a reputation.
But they can delegate policy to an independent agency (the
central bank) that is set up to take the long view.
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Overcoming the inflation bias: conservative central bankers

Aside from reputational considerations, there is another
argument for delegation (due to Rogoff), this time to an
agent who is more conservative (smaller ) than society.
Suppose we delegate decisions to a CB with preferences:
= 12 [2 + ( )2]
Repeating our earlier steps, the FOC is:
=
And the associated equilibrium is:
= [/(2 + )]
= + 2 +
The appointment of a conservative central banker ( < )
thus generates a smaller inflation bias, though also less
output stabilisation.
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Welfare under a conservative central banker

The expected social loss is then:
[ ] = 12 [2 + ( )2]
1
=
2

1
=
2

+ 2
+

2
2

+ + 2
+

2 + 2

2
+ 2 + 2

+ 2

It can be shown that / > 0 in the region of = .

In other words, it is always welfare-improving to install a
central banker with more conservative preferences than
society.

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Overcoming the inflation bias: inflation targets

Another approach would simply be to tell the CB to minimise
the loss function:
= 12 [2 + 2]
We know that minimising this loss function both eliminates
the inflation bias and generates optimal output stabilisation
(it is the case considered at the end of Topic 3).
Arguably this is what real-world inflation targeting (IT)
regimes are trying to achieve, though in practice is usually
unspecified (the contract is incomplete).
Central bank is told to achieve (close to) zero inflation, but
allowed to deviate temporarily in the face of shocks
sometimes called constrained discretion.
This is also known as flexible inflation targeting (FIT).
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Central bank independence

Both delegation to a conservative central banker and inflation
targeting require independence.
Independence can be considered along several dimensions:
Objectives and who sets them;
Who appoints CB governor and board, and for how long;
Financial arrangements.
Independence is thus a matter of degree, rather than Yes/No.
There is a well-established inverse relationship between
indices of CB independence and average inflation.
There is very little evidence that CB independence has any
adverse effect on output growth or variability.
This is exactly what our model predicts!
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CB independence and average inflation, 1955-88

Source: Alesina and Summers, JMCB, 1993

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CB independence and average real GDP growth, 1955-88

Source: Alesina and Summers, JMCB, 1993

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CB independence and variance of real GDP growth, 1955-88

Source: Alesina and Summers, JMCB, 1993

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Central bank independence: Objectives

Broad objectives usually cast in legislation:
ECB price stability enshrined in the Maastricht Treaty;
BoE price stability enshrined in the Bank of England Act;
Subject to that, both are told to support growth and
employment (Lexicographic preferences);
US Federal Reserve told in Federal Reserve Act to
promotegoals of maximum employment, stable prices, and
moderate long-term interest rates (the dual mandate).
ECB and Fed are left to decide what price stability, etc, means, but
BoE (along with many other CBs) is given a specific remit by
Government (CPI inflation of 2%) and then left free to pursue it.
ECB and Fed have both goal and instrument independence.
BoE is goal dependent but instrument independent.
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Example: Inflation targeting framework in the UK

IT adopted in 1992 after ERM exit; Chancellor set policy over 199297 but BoE commented publicly via minutes and Inflation Report.
BoE given operational responsibility for policy in 1997.
Policy set by Monetary Policy Committee of 9 (5 internals, 4
externals plus Treasury observer); 7 appointed by Chancellor.
Majoritarian decision-making, rather than consensus.
Remit provided annually by Chancellor.
Target is 2% for CPI inflation at all times;
But remit notes it is appropriate to deviate from 2% temporarily
in the face of cost shocks and (now) financial stability risks.
Open Letter of explanation if inflation >1pp away from target;
provides Chancellor scope to comment on appropriate .
Decisions explained in minutes and Inflation Report.
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UK inflation targets: an unqualified success?

As we saw earlier (slide 8),
UK inflation was very low in
the 15 years after the
adoption of IT.
CPI inflation averaged 1.8%
over Oct 1992June 2007.
It was also very stable.

Source: Bean, EJ, 2009. Chart shows rolling eightquarter forward standard deviations

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UK inflation targets: an unqualified success?

Output growth was also
very steady.
63 consecutive quarters of
expansion longest
sequence on record!
Unemployment rate drifted
down steadily from over
10% to around 5%.
Source: Bean, EJ, 2009. Chart shows rolling eightquarter forward standard deviations

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The Great Moderation: Output and inflation volatility in G5

This experience was not
unique to the UK the Great
Moderation.
But improvement in UK
economic performance was
the most pronounced.
Better conduct of monetary
policy is one of several
explanations for this fall in
volatility.
Of course, output fell sharply
after 2007. We shall say more
about this later!

Source: Bean, EJ, 2009.

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Conclusions
The presence of distortions that drive a wedge between the
efficient and natural levels of output means the first-best
monetary policy is potentially time-inconsistent.
Under discretion, this creates an inflationary bias.
The inflation bias can be avoided through the use of rules,
but these are typically inflexible and imply sub-optimal
output stabilisation.
Delegation to an independent central bank, the appointment
of conservative central bankers, and the adoption of flexible
inflation targeting regimes are complementary ways of trying
to eliminate the inflation bias while still permitting a degree
of output stabilisation in the face of cost shocks.

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