Central Bank Independence and Conservative Central Banking

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Lecture 9

• Central Bank Independence and Conservative
  Central Banking

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• This lecture extends the analysis of reputation
  and credibility to the theory of central bank
  independence

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Credibility building strategies

• Credibility building measures include
• 1) Joining and exchange rate mechanism- ERM?
• 2) Consistent fiscal and monetary policy -
  stability pact?
• 3) Independent Central Bank

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Independent CB

• This lecture will examine the third of these
  strategies
• Staring point is a Rational Expectations Phillips
  curve where x is the deviation of output from
  equilibrium.
• x (? - ?e) ?
• where ? is inflation, ?e is the expected rate of
  inflation and ? is a random shock

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Societys Iso-Loss function
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?
C2
C1
C0
0
x-
x
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Time-consistent policy is given by agents
optimising
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But the CB/government optimises
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The time-inconsistency problem

• The last 2 equations highlight the
  time-inconsistency problem
• the term bx- implies that the average inflation
  rate is above zero
• The first best policy would be to eliminate the
  inflation bias without eliminating the degree of
  output stabilisation

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But this is not credible
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The Inflation Nutter Deflationary bias
?
?lt0
C3
A
?0
C2
?gt0
B
C1
C
C
x
A
B
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Optimal set of preferences for a CB
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Substitute CB preference result into societies
loss function
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Optimising with respect to ?
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Summary

• Rogoff argues that ? lt b - we need a conservative
  CB but not too conservative
• The model can be criticised - why should society
  prefer x- gt 0 when x 0?
• Has to be argued in terms of distribution -
  political economy terms
• Minford critique - society gets the CBs they
  deserve?

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Evidence - Inflation?
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Growth Variability