term 2 - lecture 4 - credibillity and time inconsistency of monetary policy

Question 1

what is the issue with the backwards looking phillips curve?

Answer 1

The backward looking PC is ad hoc and does not allow a role for
credibility in monetary policy making to affect economic outcome.
the problem of inflation bias is usually discussed in conjunction with the problem of time inconsistency in which the central bank announces one policy but has an incentive to do otherwise.

Question 2

what is the equation of the forward looking phillips curve?

Answer 2

π_t = π(e)_t + a(y_t - y^n) + ε_t where π(e)_t is the expected inflation in period t and ε_t is the cost push shock

Question 3

what is the lucas surprise supply equation?

Answer 3

y_t -y^n = 1/a (π_t - π(e)_t) - e_t where e_t is the normalised cost push shock with the equation e_t=(1/a)*ε_t

Question 4

what is the timing of events within the period?

Answer 4

first, the private sector is commited to a fixed inflation expectation as nominal wage contracts are written in the beginning of the period. the private sector does not know e_t at the time they sign contracts; π(e)_t is not conditional on e_t
next, the central bank performs policy after having observed the shock, e_t and after inflation expectations are formed. this opens room for stabilisation of the economy against the shock, and even in absence of shocks, it opens the room for setting inflation differently from expected..
it is assumed that the private sector knows the incentive of the central bank

Question 5

what is the central banks objective?

Answer 5

the central banks objective is to minimise the loss function subject to the lucas surprise supply equation, this implies the new monetary rule of the form: y_t -y^T = -aB(π_t -π^T)

Question 6

what are the implications from the reaction function?

Answer 6

higher inflation expectations drive up inflation, a positive supply shock is met by a contractive monetary policy. the more the output goal exceeds the natural rate, the higher the inflation

Question 7

when do time inconsistency probelms arise?

Answer 7

• the central bank or government has an over ambitious output target
• wage and price setters form their inflation expectations using rational expectations
• the central bank operates with discretion: chooses its desired level of inflation/output level after inflation expectations have been formed in the private sector

Question 8

what are the three broad approaches of solving or mitigating the time inconsistency problems manifested in inflation bias?

Answer 8

replacing discretion by a rule, delegation and reputation

Question 9

how does replacing dicrection by a rule solve or mitigate time inconsistency problems?

Answer 9

if the timing of the game between the central bank and private sector is changed so that the central bank cannot choose the rate of inflation after wage and price setters have formed their expectations the inflation bias dissapears.
this entails a structure through which the central bank is prevented from optimising after the private sector has set wages and prices and is referred to as a policy of commitment rather than discretion

Question 10

how does delegation solve or mitigate time inconsistency problems

Answer 10

the inflation bias may reflect a situation in which the government rather than the central bank controls the monetary policy
the government could reduce the inflation bias by transferring control of monetary policy to a central bank with an output target closer to y^n and with more inflation aversion ie higher B than the governments
for delegation to produce a costless move from high to low inflation, there must be no inflation inertia and expectations must be formed rationally. governments have often found it necessary to make central banks constitutionally independent

Question 11

how can reputation solve or mitigate the effects of time inconsistency bias

Answer 11

interactions between the private sector and policy makers are rarely one shot nature. they occur repeatedly and this opens the possibility for reputation building. assume the interaction between the private sector and the central bank, the game, is repeated infinitely. then doing bad today may cause loss of reputation tommorow that in effect prevents the central bank from doing bad today. for this to be the case the private sector must punish bad behaviour of the central bank ie punish a deviation from the promised inflation rate. in virtually all OECD economies, central banks in most cases are independent from government and run by officals motivated by concern about their professional reputations