Discretionary Policy & Time Inconsistency Flashcards
what is a time consistent policy?
where the policy maker takes its optimal action in each period
this period by period optimisation is referred to as discretionary policy making
what is discretionary policy making?
period by period policy optimization
what is a time inconsistent policy?
where a policy maker may plan or announce a policy to be followed in the future but once at that time finds that it is no longer optimal to implement the policy
what is delegation?
where control of policy is given to an independent central bank with a loss function which differs from that of society
what is constrained discretion? and give an example.
where standard discretion is constrained
e.g. an announced inflation target
what is a bias?
when there is a difference between the time consistent and time inconsistent policies
therefore there are gains from commitment or appropriate delegation
give an example of policy.
commitment to future lower interest rates with the current interest rate at the ZLB
if the Phillips curve contains a forward looking inflation expectation such as Et[πt+1] (which iterates forward beyond t+1) higher inflation in the future will imply higher inflation now and a lower real interest rate
however, time inconsistent as once recovery occurs it is sensible to raise interest rates rather than keep them low
what are some issues with solutions to time inconsistency and bias?
delegation may make communicating policy (transparency and accountability) more difficult
both commitment (if feasible) and delegation, while initially superior by design, both involve inflexibility (required to make them credible) and hence may no longer be superior if unusual shocks hit the economy and/or our understanding of how it works changes over time
what is inflation bias? and what is it crucially dependent on?
time inconsistency problem by which the average inflation rate is too high relative to the social optimum and what could be achieved if commitment was feasible
crucially dependent on the policy maker’s output target being above the natural rate of output
what does inflation bias occur?
(i) micro distortions / “economic fundamentals”
- e.g. tax distortions, imperfect competitions, excessive minimum wages, trade unions
(ii) political motivations
- politicians constantly trying to expand economy
explain the Barro and Gordon model.
- AS is a Lucas supply function: y = yn + a(π - πe) + e
- where y is output, yn is natural output, π is inflation, πe is expected inflation and e is a random, zero mean supply shock
- assumptions:
(i) expectations formed prior to the monetary policy decision and the realisation of the supply shock (sequencing)
(ii) supply shock realised and monetary policy determined ( ⇒ scope for stabilisation policy)
(iii) output and inflation determined
- CB aims to min expected value of following loss function:
V = 1/2 λ (y - yn - k)^2 + 1/2 π^2 - expected inflation under discretion is positive and exceeds the socially optimal rate, which is zero - there is an inflation bias that is detrimental to welfare
- if inflation expectations are set at 0 the lower PC in the diagram below applied and there is an incentive for the CB to raise inflation to increase output to A. Hence the socially optimal inflation rate is time inconsistent
- incentive for CB to confound private expectations is eliminated only when expected inflation is high enough that the marginal cost of inflation offsets the benefit derived from extra output at D
what are the assumptions of the Barro and Gordon model?
(i) expectations formed prior to the monetary policy decision and the realisation of the supply shock (sequencing)
(ii) supply shock realised and monetary policy determined ( ⇒ scope for stabilisation policy)
(iii) output and inflation determined
what are the implications of the Barro and Gordon model?
a fixed rule, e.g. π = a constant will be preferable to discretionary policy, setting aside the issue of stabilisation policy if there are shocks
although the excess output ambition lies behind the inflation bias, output in excess of the natural rate will never actually be realised, at least on average
are interactions between a CB and the private sector best thought of as a repeated game or a one shot game?
interactions between CB and private sector best thought of as a repeated game, not a one shot game
what is the benefit of interactions between CB and private sector being thought of as a repeated game, not a one shot game?
repetition won’t solve bias, but opens up possibility of reputation building
marginal cost of inflation in t is not simply higher inflation in t, but also a reputation for setting high inflation in future, which will raise expected inflation and actual inflation in future periods
what are the two types of independent central bank?
(i) instrument independence (UK)
(ii) goal independence (NZ)
explain Rogoff’s conservative central banker solution to inflation bias.
Rogoff’s loss function:
VR = 1/2λ (y - yn - k)^2 + 1/2 (1 + δ) π^2
inflation weighted by (1+δ) where δ is the conservativeness (extra dislike of inflation) of the appointed CB
minimising VR will give the same results as minimising (1/1+δ)VR (a positive monotonic transformation)
⇒ ↑ in marginal cost of cheating, ↓ time consistent inflation (point R not point D)
but weight conservatism reduces the propensity for CB to dampen output shocks using counter-cyclical policy
the original MR line, “MR(dis)”, slope, -aλ, was optimal but now it will be -aλ/(1+δ) along “MR(Rog)” so output will be too variable and inflation not variable enough in response to shocks
by distorting gradient of MR (flatter), changes how CB respond to shocks (will be more extreme in response to managing inflation in terms of output)
only partial success as deals with inflation bias but at cost of changing how policy maker responds to shocks
give an example of the Rogoff solution in practice.
In the UK MPC members drawn from academia, industry, financial services, trade unions, etc - some members are naturally more averse to inflation and each member should value extra output less around election time
does evidence support the idea of Rogoff’s conservative central banker?
extent to which conservative CB model can explain trends towards increased CBI is unclear
what is Lohmann’s (1992) adaptation of Rogoff’s conservative central banker?
Lohmann (1992) shows that it is welfare improving to appoint a weight conservative CB but limit independence
in normal times CB sets policy ⇒ low time consistent inflation
in times in which the supply shock is large the government overrides CB and implements aggressive stabilisation policy
by design better than straight Rogoff but harder to implement ideas, communicate and build credibility around it
explain Walsh’s contracts for central bankers as a solution to inflation bias.
offer head of CB state-contingent payments contract
requires that government makes a transfer to CB (t) = t0 - akπ so the loss function becomes:
V = 1/2λ (y - yn - k)^2 + 1/2π^2 - t0 + aλkπ
last two terms are perfomance-related pay terms
adding linear term doesn’t change MR gradient
double success as solves both inflation bias and also the MR line is not distorted in removing it
what are the limitations of Walsh’s contracts for central bankers?
(i) what practical mechanisms can be used to implement the contract transfer in practice?
(ii) contract ensures optimal stabilisation policy after a supply shock assuming shocks do not change other model parameters
(iii) displacement problem remains
what does the evidence on the link between CBI and inflation suggest for the solutions to inflation bias?
what are some common cause explanations for the CBI/inflation relationship?
public distaste for inflation may lead to the election of anti-inflation governments who then create independent central banks in order to lock in low inflation conditions ⇒ no causal effect
Posen (1993) argues that financial sector opposition to inflation is the key driver of both inflation and CBI
is the evidence on the time inconsistency problem and the inflation bias convincing?
despite the vast theoretical literature on the time inconsistency problem and the inflation bias, it has been hard to find convincing evidence that these phenomena are important in practice
establishing causal links is difficult
fill in the blank: a ________ cross-country correlation is found between inflation performance and measures of CBI.
a NEGATIVE cross-country correlation is found between inflation performance and measures of CBI
what are the objections to evidence on CBI and inflation?
Alessina & Summers (1993) show that low inflation achieved by virtue of CBI is apparently a ‘free lunch’ (no additional volatility in real variables), but this is inconsistent with the conservative central banker hypothesis
this suggests not Rogoff as would expect a relationship between output and CBI, more consistent with Walsh as wouldn’t expect a relationship here
what are the common cause explanations for the CBI/inflation relationship?
public distaste for inflation may lead to the election of anti-inflation governments who then create independent central banks in order to lock in low inflation conditions ⇒ no causal effect
Posen (1993) argues that financial sector opposition to inflation is the key driver of both inflation and CBI
when does stabilisation bias occur? check this
occurs when the CB is forced to over-compensate for a change in the economy through raising interest rates more than the optimal amount
occurs due to an inability to commit to future interest rates
- this can happen for many reasons: e.g. limitations placed on the CB by a government, or through a loss of credibility
what loss function is used with stabilisation bias?
Assume the same loss function as before but with k = 0:
V = 1/2λ (y - yn)^2 + 1/2π^2
it is quadratic so the marginal cost of output and inflation deviations from their target values is increasing in the size of the deviation
- makes large deviations disproportionately costly
what is crucial to the existence of stabilisation bias?
crucial to the existence of stabilisation bias is the presence of a forward looking expected inflation term in the Phillips curve/AS relationship
what is the NKPC form for stabilisation bias?
NKPC form:
πT = βEt[πt+1] + γ(yt - yn) + εt
under NKPC how does expected inflation react to a shock?
under NKPC, expected inflation can react contemporaneously to the cost push shock (not the case with adaptive expectations)
what is a key insight with stabilisation bias under NKPC?
key insight is that, under discretion, Et[πt+1] is not under the control of the policy maker, it is a given, so the best that they can do if there is a cost push shock t>0 is to “share” its impact on and y according to the optimal MR line
what does credibility have to do with stabilisation bias under the NKPC?
if commitment is feasible the “spikes” when the shock hits can be made smaller by manipulating Et[πt+1]
if a credible commitment is made at time t to make inflation at t+1 negative this effectively offsets part of the impact of t>0 so the combined contemporaneous impact on and y can be smaller
how do commitment and discretion differ to generate stabilisation bias?
under commitment Et[πt+1] effectively becomes an additional policy instrument for dealing with the time t shock
this is not possible under discretion because once time t+1 arrives no earlier promise is binding (it is time inconsistent) and the policy maker will simply react to the time t+1 shock ignoring the past
thus commitment and discretion differ so there is a bias and it’s called stabilisation bias as it relates to stabilising the economy when shocks occur
