LECTURE 6:
DYNAMIC INCONSISTENCY OF MONETARY POLICY,
AND HOW TO ADDRESS IT
Question: Why is inflation, π, often high?
Why π > 0 more often than π < 0?
One of several answers:
Proclamations of low-inflation monetary policy
by central banks are “dynamically inconsistent.”
Next question:
What institutions can address dynamic inconsistency?
API-120 Prof. J.Frankel
Inflation is usually > 0
and was a chronic problem during 1950-2000.
Source: Carmen Reinhart & Ken Rogoff, This Time is Different:
A Panoramic View of Eight Centuries of Financial Crises.
If monetary expansion can’t reduce unemployment
in the long run, why is inflation so common?
Four possible explanations:
 Governments think expansion can reduce
unemployment in the long run.
 They give low weight to price stability,
or have high discount rates (e.g., political business cycle).
 Plans to set non-inflationary monetary policy
are perceived by the public to be time-inconsistent.
 Governments want seignorage, to pay for spending
that is not financed by taxes or borrowing.
API-120 Prof. J.Frankel
Dynamic inconsistency: The intuition
• Assume governments, if operating under discretion,
choose monetary policy and hence AD
so as to maximize a social function of Y & π.
–
=> Economy is at tangency of AS curve &
one of the social function’s indifference curves.
–
Assume also that the social function centers on 𝑌 > 𝑌 ,
even though this point is unattainable, at least in the long run.
• Assume W & P setters have rational expectations.
–
–
=> πe (&  AS) shifts up if rationally-expected E π shifts up.
=> πe = E π
= π on average.
•  economy is at point B on average. Inflationary bias: πe = E π > 0.
•
• Lesson: The authorities can’t raise Y anyway,
so they might as well concentrate on price stability at point C.
3. But πe adjusts
upward in response
to observed π>0.
The LR or Rational
Expectations
equilibrium must
feature πe = π.
Result:
inflationary bias π>0,
despite failure to
raise Y above 𝑌 .
4. The country
would be better off
“tying the hands”
of the central bank.
Result: π=0.
And yet Y = 𝑌
(no worse than average
under discretion).
2. If πe would
stay at 0,
π
πe
then to get
the higher Y
it would be
worth paying
the price
of π>0.
●
●
●
𝑌
API-120 Prof. J.Frankel
•
Yˆ
1. Barro-Gordon
innovation:
It is useful to
think of society’s
1st choice as Y=𝑌
(& π=0), even if it
is unattainable.
Time-Inconsistency
of Non-Inflationary Monetary Policy
y  y   (   )
e
(Romer 11.53)
+ Policy-maker minimizes quadratic loss function:
(11.54)
 
1
( y  yˆ ) 
2
2
1
a ( )
2
2
where the target yˆ  y.
=>
 
1
( y   (   )  yˆ ) 
e
2
2
1
2
API-120 Prof. J.Frankel
a ( )
2
Given discretion, the CB chooses the rate of money growth
and inflation (assuming it can hit it) where
d
d
 ( y   (   )  yˆ )  a ( )  0
e
Take the mathematical expectation:
( y   E (   )  yˆ )  aE ( )  0 .
e
+ Rational expectations:
(11.58)
(10.15)
E 

  E
e
=>
( yˆ  y )  0 , the inflationary bias.
a
API-120 Prof. J.Frankel
.
ADDRESSING
THE TIME-INCONSISTENCY PROBLEM
 How can the CB credibly commit
to a low-inflation monetary policy?
 Announcing a target π = 0 is time-inconsistent,
because a CB with discretion will inflate ex post,
and everyone knows this ex ante.

CB can eliminate inflationary bias
only by establishing non-inflationary credibility,
 which requires abandoning the option of discretion.
 so public will see the CB can’t inflate even if it wants to.
 CB “ties its hands,” as Odysseus did in the Greek myth.
API-120 Prof. J.Frankel
Addressing the Time-Inconsistency Problem (continued)
 Reputation
 Delegation. Rogoff (1985): Appoint a CB with high weight
on low inflation a′ >> a , and grant it independence.
It will expand at only
 

a
( yˆ  y )
<< inflationary bias of discretion.
 Binding rules. Commit to rule for a nominal anchor:
1. Price of gold
3. Exchange rate
5. CPI
2. Money growth
4. Nominal GDP
6. GDP deflator
API-120 Prof. J.Frankel
Addressing the Time-Inconsistency Problem (continued)
• Reputations. With multiple periods, a CB can
act tougher in early periods, to build a
reputation for monetary discipline.
– Backus-Driffill (1985) model:
people are uncertain if the CB is of
hard-money or soft-money “type.”
– Then even a soft CB may act tougher,
to influence subsequent expectations.
API-120 Prof. J.Frankel
• Delegation
Alesina & Summers: Central banks
that are institutionally independent
of their governments have lower
inflation rates on average.
API-120 Prof. J.Frankel
for transition
economies
“Central Bank Independence, Inflation and Growth in Transition Economies,”
P.Loungani & N.Sheets, IFDPS95-519 (1995)
API-120 Prof. J.Frankel
Limitations to the argument
for central bank independence
1. Some consider it undemocratic.
2. The argument only works if
the right central bankers are chosen.
3. Although independence measures are inversely correlated
with inflation, these measures have been debated and,
4. more importantly, the choice to grant independence could
be the result of priority on reducing inflation.
5. As with rules to address time-inconsistency,
there is little empirical evidence that it succeeds
in reducing inflation without loss of output.
6. As with rules, one loses ability to respond to SR shocks.
API-120 Prof. J.Frankel
Inflation Targeting (IT)
Five advanced
countries
adopt IT:
199093
Many developing
countries
adopt IT:
19992008
Agénor & Pereira da Silva, 2013, Fig.1.
"Rethinking Inflation Targeting: A Perspective from the Developing World," CGBCR DP 185, U.Manchester. .
Countries adopting IT experienced lower inflation
Gonçalves & Salles, 2008, “Inflation Targeting in Emerging Economies…” JDE
API-120 Prof. J.Frankel
by tying hands
Introducing disturbances into the Barro-Gordon model
à la Rogoff (1985) and Fischer (1987)
AS shocks
No effect on inflation bias. Average inflation =
E 

( yˆ  y )
a
Shocks will show up as fluctuations in actual  & y.
But discretionary monetary policy can’t offset AS shocks anyway
(can only choose the split  vs. y).
=> Strong case for committing to E=0.
AD shocks
Again no effect on inflation bias. Need not show up as fluctuations in
actual  & y : If lags in monetary policy < lags in adjustment
of W & P, under discretion CB can offset AD shocks.
=> Choice of rules vs. discretion then becomes choice of
eliminating LR inflation bias (E=0) vs. SR shocks.
API-120 Prof. J.Frankel
Appendix 1: GLOBAL INFLATION
HAS DECLINED SINCE 1990. WHY?
 Better understanding of costs of inflation
and the temporariness of the AS tradeoff ?
 Spread of commitment devices such as central bank
independence, hard exchange rate pegs
(currency boards & monetary unions), & IT?
 Rogoff (2003): Globalization & increased competition
have reduced  and/or ( yˆ  y )

and thereby the inflationary bias ( yˆ  y ) .
a
peak:
early 80s
API-120 Prof. J.Frankel
Continued from
previous
peak:
≈ 1990
peak:
early 90s
API-120 Prof. J.Frankel
Appendix 2: Targets & Instruments of Policymaking
OBJECTIVES
Inflation
Growth & Unemployment
Balance of payments
INSTRUMENTS
INTERMEDIATE TARGETS
Overnight interest rate
Open market operations
Reserve requirements
Foreign exchange intervention
M1
Exchange rate
Core CPI
Nominal GDP
INDICATORS
Stock market, Commodity prices,
Consumer confidence, PMI …
Appendix 3:
Comparison of alternate rules
(M1 vs. E vs. CPI …)
The choice of anchor depends on:
1. Credibility of the commitment
2. Tradeoff: advantage of time-consistent commitment
vs. ability to stabilize short-term shocks

Must compare E(Loss) function for M vs. GDP
vs. ex.rate vs. P targets)

Original treatment due to Rogoff (1985)
3. Other objectives served (e.g., a peg cuts exchange rate risk)
API-120 Prof. J.Frankel
6 proposed nominal targets and the Achilles heel of each:
Monetarist
rule
Inflation
targeting
Nominal GDP
targeting
Gold
standard
Commodity
standard
Fixed
exchange rate
Targeted
variable
Vulnerability
Example
M1
Velocity shocks
US 1982
CPI
Supply/import
price shocks
Oil shocks of
1974, 1980, 2008
Nominal
GDP
Measurement
problems
Vagaries of
Price
world gold
of gold
market
Price of agr.
Shocks in
& mineral
imported
basket
commodity
$
Appreciation of $
(or euro)
(or other)
API-120 Prof. J.Frankel
Less developed
countries
1849 boom;
1873-96 bust
Oil shocks of
1974, 1980, 2008
1995-2001