Economics Update (April-June 1998)

Central Bank Design and
Policy Credibility

I n recent years several countries have granted greater independence to their central banks, while other countries have made price stability the only objective of their central bank's monetary policy. According to recent research, these two trends can be seen as social responses to a fundamental problem of central bank credibility called the time inconsistency of monetary policy.

The theory of time inconsistency and some of its empirical aspects are the subject of an article by Roberto Chang in the Atlanta Fed's Economic Review (First Quarter 1998). The theory emphasizes that, if a central bank cannot credibly commit to honor announcements of a low inflation target, expected and actual inflation will be larger than if a credible commitment could be made. In other words, time inconsistency leads to an inflation bias. To minimize these inflationary consequences, countries may institute price stability rules or grant their central banks independence from other branches of the government.

But the empirical evidence Chang reviews does not provide strong confirmation that central bank independence by itself can eliminate inflation bias, so its emergence will not necessarily yield lower inflation. The results may reflect that reputation has played a role in minimizing time inconsistency or that the degree of central bank independence is determined by reasons other than eliminating inflation bias.

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