Anti-Inflationary Policies and the Issue of Credibility of Central Banks

Topics: Inflation, Central bank, Monetary policy Pages: 8 (1902 words) Published: May 12, 2011

Anti-inflationary policies are the policies taken by the government to announce inflation target lowering it to zero, in the beginning of the year, which at that time is considered optimal. The government wants to keep the inflation level low in an economy. It is the continuous rise in the general price level of goods and services over a period of time in an economy. As we know inflation can cause serious social consequences, if it’s not perfectly anticipated, money as a measure of value or as a medium of exchange is undermined.

The issue of credibility

The announcement of the government of anti-inflation will form expectations and be embedded into contracts. Wage contracts are also signed in this period. In this circumstance, the policymaker has a chance to induce a surprise inflation leading to an increase in inflation level and a decrease in the level of unemployment. This may be desirable, particularly if the natural level of unemployment is considered too high from a social point of view, so that during the year a higher inflation would have been optimal. And as this has been undertaken by the government a number of times, the announcements are not considered credible. The private sector can foresee the consequent move by the government and does not take into account the announcement, since in the past the government induced surprise inflation, although this inducement is not the response to any change in the environment but the change in policy action of the private sector itself. This brings in the time-inconsistency problem, where there are considerable two players, private sector and the policy maker (here, government).

Knowing that the final unemployment rate would be UN, the government choose to minimise inflation by promising to drive down π to 0. The private sector then predicts the government’s final move and makes a choice regardless of the policy and forces the policy maker to make the final decision at π > 0, which means accommodating positive inflation with no gain in unemployment level: inflationary bias. And countries with high inflationary bias are said to have the credibility problem as the private sector realise the government’s incentive for inducing surprise inflation. This lack of credibility leads to an undesirable aftermath. The monetary authority will have to accommodate higher wage pressures and inflationary expectations in order to keep the unemployment level in control. Although, according to the literature by Kydland and Prescott in 1977 the credibility problems occurs when the monetary authorities have the short run incentive to achieve an output or employment target that is above the NAIRU OR market-clearing level. It can even arise in the absence of conflict of objectives between the private sector and policy maker. The time-inconsistency also arises even if policy maker decides to stabilise the economy at NAIRU but with forward-looking variables like inflation or long-run interest rate or even exchange rate.

Solution to time-inconsistency problem

The main solution to this time-inconsistency problem causing an inflationary bias, could be a constitutional rule, or a central bank independence combined with an optimal inflation contract (Walsh,1998) or an optimal inflation target (Svensson,1997a).

And it is Rogoff who has proposed to delegate monetary policy to an independent and conservative central banker to reduce the inflationary bias. This meant that inflation stabilisation would be given up for output stabilisation. The numerical analysis below explains how the degree of independence and conservativeness effect the level of inflation. (Berger, Haan & Eijffinger,2000)

The policymakers seek to minimise the loss function of the government which is ……………………………………………..

…… is output

…… is desired output

….. is government’s weight on output stabilization

Lucas supply function by which output is driven is ……………………………………………..

… actual...

References: • “Monetary policy rules, policy preferences and uncertainty: recent empirical evidence” by Anton Muscatelli and Carmine Trecroci (2000). Journal of Monetary Economics, 43, 1999, 579-605.
• “International experiences with different monetary policy regimes” by Frederic S Mishkin(1999). Journal of Economic Surveys, 2001, 14, 597-627.
• Analysis of time-inconsistency problem of optimal discretionary monetary policy
• Monetary policy targets and rules: Review of “International experiences with different monetary policy regimes” by Frederic S Mishkin(1999)
• Friedman and Kuttner(1996)
• Cukierman and Grilli et al
• Posen(1995)
• Svensson(1997)
• Walsh(1995)&(1998)
• McCallum (1995)
• Eijffinger and Hoeberichts ( 1998),
• Kydland and Prescott(1977)
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