Week 2 - Central bank independence

Question 1

What causes the SR Phillips curve to shift up?

Answer 1

1. Workers form a HIGH INFLATION EXPECTATION
2. Workers INCREASE WAGE DEMANDS to maintain real wages, to make up for higher cost of living.
3. Firms’ labour cost increase, hence respond by pushing up prices to maintain profit margins, thus inflation increases
4. SR Phillips curve shift upwards

Question 2

Time inconsistency

Time inconsistency of monetary policy & electoral incentives

Answer 2

Long term objectives are incompatible with short term temptation

1. Governments understand that a low inflation policy is in the long term interests of society
2. but they cannot stick to it due to their short term ELECTORAL incentives
3. Govt pressures the central bank to reduce interest rates to STIMULATE AGGREGATE DEMAND & OUTPUT in the short term, -> faster real growth & lower unemployment…
4. …at the cost of HIGHER INFLATION in the LONG TERM (inevitable trade-off)

Question 3

What is the only way for unemployment to fall?

Answer 3

Through an inflation SURPRISE
ie. when workers’ inflation expectations were low but suddenly inflation increased // if actual inflation deviates from expected inflation

Question 4

Adaptive expectations

Answer 4

• Workers are slow to adjust to changes in inflation
• but in the LR, expectations fully adjust and catch up with reality

{hence inf exp remain low when unemployment falls & gov wins the election}

Question 5

Overall, why is society worse off from the pre-election boom?

Answer 5

Because the economy is stuck in a high inflation equilibrium (govt’s inability to control inflation)

Question 6

Inflation bias

Answer 6

1. Public realised that gov was PERPETUALLY TEMPTED to inflate the economy.
   - responded by raising inf exp b/c didn’t trust gov and knew they will be caught by an inflation surprise and real wages will be eroded
2. So, Infl exp & inflation ratcheted permanently higher, so inflation itself is permanently higher ← inflation bias.

Question 7

Benefit of central bank independence - monetary policy is out of governmental control

Answer 7

• Central bank has no temptation to increase inflation b/c unaffected by short run electoral concerns
• so, commitment to low inflation becomes CREDIBLE {-> no more inflation bias}

Question 8

Main problem of central bank independence

Answer 8

• Gov has accountability for economic mismanagement b/c can be punished by throwing out of gov (govts are accountable to the electorate)
• Need to create incentives for central bank to control inflation/manage economy well, thus COMBINE CB independence w/ an EXPLICIT INFLATION TARGET to make the Governor accountable for their actions.
• If fail to meet target consistently, the Governor is punished usually.
  eg. contract termination in NZ, open letter in the UK if miss target by >1 percentage point in either direction
• Even in countries which don’t impose explicit penalties, there will be lost reputation/prestige from missing the target badly

Question 9

2 benefits of inflation targeting

Answer 9

1. Increases TRANSPARENCY, helps public to ‘ANCHOR’ INFLATION EXPECTATIONS (in the face of a supply shock)
   - A temporary increase in inflation does not become permanent
   ^avoids a WAGE PRICE SPIRAL & get a self-fulfilling equilibrium,
   ie. if ppl believe inflation will go down, it will. if believe will go up, will go up.
2. Anchoring means that the central bank can control inflation W/O actually increasing INTEREST RATES
   - the credible threat of raising rates is enough to maintain inf exp

+ Output & Employment stability are not a problem w/ DEMAND shocks due to the DIVINE COINCIDENCE

Question 10

Cost of inflation targetting

Answer 10

NARROW FOCUS ON PRICE STABILITY, therefore
Lack of flexibility in dealing w/ SUPPLY SHOCKS

• With a supply shock the central bank faces an inevitable trade-off between inflation & output stabilisation
  (Output and inflation move in opposite directions.)

Bonus mark: A more flexible inflation targeting framework could achieve similar benefits to the dual mandate,
eg. specifying a range for inflation outcomes

Question 11

A negative supply shock causes STAGFLATION. What is stagflation?

Answer 11

Inflation + recession

Question 12

Inflation nutter vs Unemployment nutter

*Divine coincidence does NOT apply for supply shocks.

Answer 12

Inflation nutter, eg. Bank of England
- Must increase interest rates, engineer MONETARY CONTRACTION, AD curve shifts to left and return to inf target at point C.
- Exacerbates OUTPUT & employment FLUCTUATION, severe RECESSION

Unemployment nutter
- Only cares about reducing unemp to natural rate, does not care about inflation.
- Monetary accommodation of the supply shock.
- Exacerbates surge in INFLATION problem

Question 13

Dual mandate + its key benefit

Answer 13

Dual objectives of the US Fed - achieve both…
1. Price stability &
2. maximum employment
(inflation & output stability)
» Flexibility in the face of SUPPLY SHOCKS

No surging inflation, no huge recession. Located in the median between 2 extremes

AD curve shifts to the right, but not as much as with unemp nutter. Moves B → E
Moves to point D, increase in inflation.

Question 14

Taylor Rule

Answer 14

The Fed’s conduct of monetary policy is described by the Taylor Rule - INTEREST RATES should increase by 1/2% for each…
1. 1% increase in INFLATION above target
2. 1% increase in OUTPUT above the natural rate

Question 15

2 cons of a dual mandate…

…that the authors (Bernanke and Mishkin, 1997) recommend moving instead to a formal inflation targeting regime (allows transparency)

Answer 15

1. Decrease TRANSPARENCY of the monetary policy framework
   - Suppose inflation is rising & the Fed cuts interest rates,
   i) public doesn’t know if it’s for the ACCOMMODATION of SUPPLY SHOCK or
   ii) is the Fed inflating the economy due to POLITICAL PRESSURE
   - Hence might UNDERMINE ANCHORING of inflation expectations
   - & create harmful financial and economic uncertainty
2. The Fed’s current approach also RELIES heavily on a SINGLE INDIVIDUAL’S preferences for low inflation, but what happens when a new Governor takes over?

Question 16

Rogoff’s conservative central banker & get the best of both worlds of…

Answer 16

• Has a strong aversion to inflation.
• Only cut interest rates when really necessary, when really due to supply shocks
• If a conservative Chairman cuts interest rates & inflation rises, more likely for ACCOMMODATION of SUPPLY SHOCK b/c hates inflation and won’t purposely inflate economy. Public knows this.

1. Inflation expectations remain ANCHORED
2. Allows governor FLEXIBILITY in policy response for severe supply shocks

Question 17

How might publishing regular inflation reports to increase the TRANSPARENCY of the monetary policy framework help the central bank to mitigate the time inconsistency of monetary policy?

Answer 17

1. CB is obligated to make explicit that the SHORT-RUN BENEFITS of this policy (faster real growth and lower unemployment) may well be purchased at the price of LONG-TERM INFLATION,
   - thus help the public to understand the long term negative consequences
2. CB governors dislike admitting publicly that they are off track from meeting their inflation targets

Question 18

3 modifications the authors suggest to increase the flexibility of the inflation targeting framework (Bernanke and Mishkin, 1997)

Answer 18

1. The inflation target can be defined to EXCLUDE the FIRST-ROUND EFFECTS of some IMPORTANT SUPPLY SHOCKS from the TARGET MEASURE,
   eg. changes in food and energy prices or in value-added taxes.
   - If inflation expectations are WELL-ANCHORED then there would be NO SECOND-ROUND EFFECTS
   and inflation would GRADUALLY REVERT to target without requiring any monetary response
2. Targeting a RANGE e.g. 1 - 4%, rather than an explicit point target allows additional room for the central bank to HOLD OFF on MONETARY TIGHTENING until inflation breaches the pre-specified ceiling, thus MITIGATING the costs of OUTPUT INSTABILITY
3. ADJUSTING the target to ACCOMMODATE the effects of SUPPLY SHOCKS or other “unavoidable inflation” OUTSIDE the CB’s control similarly allows the central bank to TRADE OFF inflation stabilization for OUTPUT STABILISATION in the short term
   eg. after the 1979 oil shock the Bundesbank {German CB} TEMPORARILY INCREASED its inflation target to 4%

Question 19

What is the trade-off involved in specifying an inflation target range rather than a point target in terms of INFLATION UNCERTAINTY? (Bernanke and Mishkin, 1997)

Answer 19

Increases INFLATION UNCERTAINTY
- eg. discouraging long-term saving and investment decisions,
- exacerbates relative price volatility,
- & increases the riskiness of nominal financial and wage contracts

Question 20

What is the trade-off involved in adjusting (increasing) the inflation target to accommodate effects outside of CB’s control in terms of UNDERMINING INFLATION EXPECTATIONS? (Bernanke and Mishkin, 1997)

How does increased transparency mitigate this disadvantage?
eg. after the 1979 oil shock the Bundesbank TEMPORARILY INCREASED its inflation target to 4%

Answer 20

1.Public might believe that an increase in the inflation target is driven by a POLITICALLY PRESSURED central bank’s attempt to spring an INFLATION SURPRISE and decrease UNEMPLOYMENT,
- such that the TIME INCONSISTENCY problem resurfaces & inflation expectations rise

2. CB would be forced to JUSTIFY why the inflation target has been adjusted, provide evidence for the NEED for SHORT TERM OUTPUT STABILISATION and give a convincing explanation that the increase in inflation is only TEMPORARY and would RETURN to LONG RUN EQM as economic conditions normalized.

Question 21

2 ways the dual mandate can achieve similar benefits to an explicit inflation target (Bernanke and Mishkin, 1997)

Answer 21

1. Appointment of a “CONSERVATIVE CENTRAL BANKER”
   ie. a Fed chair with a STRONG AVERSION to inflation
   > achieves the best of both worlds:
2. Inflation expectations remain ANCHORED
3. Allows short-run FLEXIBILITY in policy response for severe supply shocks
   > the public realises that the “inflation-hating” Chair would never intentionally inflate the economy
4. Appointing on LONG TERMS OF OFFICE may induce “dovish” Federal reserve governors to MIMIC the behaviour of a conservative central banker due to REPUTATION EFFECTS,
   ie. being tough on inflation in the short term yields LONG TERM BENEFITS in terms of anchoring inflation expectations