L9 - Time Consistent Monetary Policy and Central Bank Independence

Question 1

What is the Rule-based monetary policy?

Answer 1

• Rule - the setting of monetary policy based on regulations or a ‘rule’, that policy makers will abide by
  
  • the use of commitment technology to limit the discretion of policy-makers from changing an interest rate from an agreed value
  • an example is the inflation target of 2% CPI
  • they are used to help simplify the decision making process of those at central banks
• Discretion - where the central bank reacts to economic conditions and adjusts monetary policy occuring to the judgement of policy makers and not some predetermined model or target - this can sometimes be done on a case-by-case basis

Question 2

What is the Discretionary monetary policy?

Answer 2

• Discretion - where the central bank reacts to economic conditions and adjusts monetary policy occuring to the judgement of policy makers and not some predetermined model or target - this can sometimes be done on a case-by-case basis

Question 3

Tavlas (2015)?

Answer 3

notes that policy rules for which the quantity of money plays a key role were a central feature of the Chicago monetary tradition from the mid-1930s through the late-1970s

REVIEW

Question 4

Who formulated the two most prominent rules in monetary policy?

Answer 4

• Henry Simons
• Milton Friedman
  
  • (for whom following a rule would eliminate ìthe danger of instability and uncertainty of policyî, a view also held by Simons)

Question 5

Simons (1936,1946)?

Answer 5

proposed a rule that targeted a constant price level in the short run

Question 6

Friedman (1958,1960)?

Answer 6

advocated a rule that targeted a constant rate of growth of the money supply (the ‘k-percent’ rule)

Question 7

What happened during the attempt to control the money supply in the 1980s?

Answer 7

In the early years of the 1980s, Mrs Thatcher embarked on a policy of Monetarism. This involved trying to target the money supply to reduce inflation. It involved:

• Higher interest rates
• Higher taxes and spending cuts.
  
  • Monetarism can also involve deregulation, privatisation of state-owned assets and reduce the power of trade unions

These policies were successful in reducing inflation, but, combined with a strong pound they led to a deep fall in output. Unemployment rose to three million and there was a very significant decline in manufacturing output.

Unemployment remained high throughout the 1980s, suggesting a rise in structural unemployment as a result of the decline in traditional manufacturing firms.

Question 8

What was a recent rules versus discretion debate?

Answer 8

• More recently, the rules versus discretion issue featured at the heart of a debate between former Fed chair Ben Bernanke (favouring ‘constrained discretion’) and John Taylor (favouring ‘rules-based’ monetary policy).

Question 9

What is time Consistency?

Answer 9

According to Cecchetti and Schoenholtz (2019):

• “The problem of time consistency is one of the most profound in social science. With applications in areas ranging from economic policy to counterterrorism, it arises whenever the effectiveness of a policy today depends on the credibility of the commitment to implement that policy in the future.”

Question 10

Example of Time-consistency in an educational setting?

Answer 10

• (Mankiw, 2006)
• To encourage you to work hard, your professor announces that this course will end with an exam. But after you have studied and learned all the material, the professor is tempted to cancel the exam so that he or she wonít have to grade it
• this is an example of being time-inconsistent - if students know you are going to cancel the exam, it will affect theri effort

Question 11

Example of Time-Consistency in a Political Setting?

Answer 11

• Mankiw
• Often in hostage situation, governments announce policies that they will not negotiate with terrorists
• This is meant to deter terrorist from taking hostages as there is no value in it - the announcement is to influence their expectations
• Unless the policy makers stick to this ‘rule’ it will have the opposite effect (if terrorist know they will end up negotiating they may take even more hostages)
• So the only way to deter rational terrorist is to take away any discretionary decision making from policy makers and make them commit to the rule of never negotiating
• Although this theory is largerly based on the rationality of a terrorist

Question 12

What is the purpose of the Barro-Gordon Model?

Answer 12

• The one-shot game based on Barro and Gordon (1983)- fucuses on whether policymakers should adhere to rules or conduct policy according to discretion
• This model will now introduce:
• a Phillips curve specification or Lucas Supply Curve capturing the relationship between unemployment and inflation, and
• a loss function , which specifies the preferences of the monetary authorities (or society) over inflation and unemployment. –> basically a utility function

Question 13

What is the Phillips curve relation?

Answer 13

Question 14

What is the Loss Function?

Answer 14

• Measures the amount of disutility felt by the monerart authorities
• Larger values of L represent higher levels of disutility: therefore make L as small as possible –> L is treated as a ‘bads’ indifference curve - more is worse thus we want to minimise its affecr
• kUⁿ –> is the target level of unemployment in which k falls between 0 and 1
• Amounts to saying that the government wants to drive unemployment below is natural level –> lower unemployment, higher output (Okun’s Law)
• Clearly, as deviations in unemployment away from its target level increase, so too will the value of (U -kUⁿ)² –> any deviation from 0 inflation regardless whether it is positive or negative it will cause equal amounts of disutility, which rising at an exponential rate

Question 15

What did some policy-makers say about the governments aim to drive unemployment below its natural level?

Answer 15

• They are doing this to create surprise inflation - the fundamentals of the Barro-Gordon model is therefore quite dubious
• Obviously this idea was disregarded by the central bank

Question 16

What is ‘b’ in the loss function?

Answer 16

• used to describe the extent to which the monetary policy maker cares about unemployment targets relative to inflation–> how much they care about hitting their unemployment target
• when b = 0 –> the policy-maker only cares about meeting inflation targets
• when b –> ∞ –> the policy-maker cares only about unemployment and not inflation

Question 17

What is the Best Response Function to the One-shot game of the Barro-Gordon Model?

Answer 17

• where Φ(π^e) is the central bank’s best response function (BRF), and equation 4 is the the private sector’s expectation of what inflation should be
• The inflation rate set by the monetary authority (π) is a function of the inflation rate expected by the private sector (π^e ).

Barro and Gordon ask following question: should monetary policy be conducted by discretion, or according to binding rules?

• To answer this, informative to look at effect on the loss function (L) and unemployment (U) when the monetary authorities and the private sector behave in different ways –> the private sector knows the policy-makers utility function and this then effects how they will react to a given policy change and what their expectation of inflation will be

Question 18

What are the 3 scenarios that can occur based on the Barro-Gordon Model with repect to expected inflation?

Answer 18

1. Surprise Inflation vs. Monetary Rules
2. The private sector is Not Stupid
3. What if the monetary authorities still follow a rule given the private sectorís rational expectation of π^e = ab(1-k)Uⁿ

Question 19

Why is the private sector important in the Barro-Gordon Model?

Answer 19

Wage setting behaviour

Question 20

Scenario 1: Suprise Inflation vs. Monetary rule?

Answer 20

• The first one is where the policy-maker cheats and set inflation to being positive
• The second is where the policy-maker sticks to its monetary rule of 0% inflation

Question 21

Scenario 2: The Private Sector is Not Stupid?

Answer 21

• the private sector has Ration Expectations –> their is common knowledge between the private sector and the central bank - they know their utility function and what they want to do
• if the central bank knows what expected inflation will be –> it will incorporate the expectations into its model when setting actual inflation targets
• its not possible for the central bank to push unemployment below its natural rate even if it wants to as the private sector will simple adjust their expectations keep it at its natural level

Question 22

Scenario 3: What if the monetary authorities still follow a rule given the private sectorís rational expectation of π^e = ab(1-k)Uⁿ?

Answer 22

• Still sets inflation=0 but the private sector still expect the central bank to ‘cheat’

Question 23

What is the summary of all the loss function of each scenario?

Answer 23

Question 24

What does the ordering of the Loss functions tell us?

Answer 24

Question 25

The Solution to the Barro-Gordon model depicted on a graph?

Answer 25

• the model shows that central bank should follows rules, and the only way for them to do so if there is legislation in place to force them to do so - otherwise it will cheat under discretionary monetary policy
• (black downards lines are expectation-augmented Phillips-Curves)
• grey curves are utility functions
• weird tick is inflation
• right hand graph has a 45-degree line of actual inflation = expected inflation and the Best Response Function
• Solution occurs at point b

Question 26

Why is the Barro-Gordon Model useful?

Answer 26

Economists have devised simple abstract models that have been highly influential in shaping how real world monetary policy is conducted.

• The Barro-Gordon model is one such model: this model (and more generally the notion of time-consistent monetary policy) has influenced the trend for central banks to be given greater independence over the past three decades;
• CBI (central bank independence) permits central banks to follow ‘rules’ more easily (e.g., they are less susceptible to political interference).

Question 27

What are the criticisms of theoretical models such as the Barro-Gordon Model?

Answer 27

• the role of time is typically ignored (the model covered in this handout is a ‘one shot’ game) –> engaging with the private sector on a daily and yearly basis - need a repeated game which is neglected in this model
• in reality, the central banks use the short term interest rate (and more recently asset purchases) as the main tool of monetary policy. –> dont have perfect control over inflation
• Nevertheless, the Barro-Gordon model provides a very useful and analytically rigourous economic framework for exploring issues in monetary policymaking.

Question 28

How do academic economist measure the independence of central banks?

Answer 28

• Looking at the statutes of the Central Banks - the laws governing how they function
  
  • Used to test both Political and Economic Independence

Question 29

What are the strengths of the empirical evidence?

Central Bank Independence and Economic Performance

(Pollard, 1993)

Answer 29

Looking at empirical studies of the relationship between central bank independence and inflation, fiscal deficits and real growth

• If a country wants to lower inflation without hurting growth it would do best to create an independent bank
  
  • Such a Central bank could help reduce fiscal deficits and increase output
    
    • Grilli et al. commented about independent central banks “there are benefits but no apparent costs in terms of macroeconomic performance”

Question 30

What are the weaknesses of the empirical evidence?

Central Bank Independence and Economic Performance

(Pollard, 1993)

Answer 30

1. difficulty in actually measuring central bank independence
   
   1. based on legal measure of independence - which may not be the same as practical independence
2. possibility of a spurious relationship between independence and economic performance
3. the possible endogeneity of central bank independence
4. the inclusion of the fixed exchange rate period in the sample data of some studies

Question 31

How is a spurious relationship between economic performance and central bank independence a weakness of the empirical evidence?

Central Bank Independence and Economic Performance

(Pollard, 1993)

Answer 31

• are there other factors than independence that can influence the rate of inflation including political variables (Grilli et al., 1991)
• (Cukierman, 1992) - monetary policy is generally sensitive to shocks to government revenues and expenditures, employment, and the balance of payment
  
  • These can affect a central bank economic performance
    *

Question 32

What are the strengths of the theoretical evidence?

Central Bank Independence and Economic Performance

(Pollard, 1993)

Answer 32

• noncoordination of fiscal and monetary policies will result in a suboptimal economic performance from the perspective of both the government and the central bank.
• Policy targets are more closely met when coordination occurs.
• Thus an independent central bank is not conducive to achieving better policy outcomes.

Question 33

What are the weaknesses of the theoretical evidence?

Central Bank Independence and Economic Performance

(Pollard, 1993)

Answer 33

• Assume certainty ( Policy is not made in a world of certainty
  
  • Extrinsic uncertainty—shocks to the economy—can drive a wedge between the implementation of policy and its outcome
• If the public has not been included in the policy game
  
  • their perception of the credibility of the policy can limit the ability of policymakers to take advantage of an inflation/output tradeoff (Blackburn and Christensen,1989)
• Models are too simplistic - dont have preference structures for the two authorities nor the model of the economy (not sure is apply to Barro-Gordon model)

Question 34

Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence

(Alesina and Summers, 1993)

Answer 34

• monetary discipline associated with central bank independence reduces the level and variability of inflation but does not have either large benefits or costs in terms of real macroeconomic performance. (Alesina and Summers, 1993)

Question 35

Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence

(Summers, 1988)

Answer 35

• Rule-based policies advocates stress they can avoid inflation
• While it is possible that rule-based performance would be superior to discretionary performance on stabilization grounds, Summers (1988) notes a number of reasons why this is unlikely including unforeseen events and the possibility of an economy getting trapped in the neighbourhood of a suboptimal equilibrium around which stabilization would be undesirable