Current controversies in the literature on time inconsistency and monetary policy

Abstract

I examine the importance of the inflationary basis of time consistent monetary policy by using an extended version of the simple Barro-Gordon framework featuring important aspects of actual policy making. The model developed provides a counterexample to the standard theory as it yields the result that a deflationary bias may be possible as well. I identify the rationale for this surprising result in the distortion caused by instrument uncertainty in the trade-off between the costs and benefits associated with surprisingly lower interest rates faced at the margin by the policy maker.

A key debate in monetary policy is that on the importance of following systematic behaviours. I revisit the debate on rules versus discretion focusing on the design of instrument rules in a manner that push discretionary policy choices in the direction of the commitment equilibrium. I demonstrate that an instrument rules with an optimal degree of monetary inertia may render negligible the inflationary bias associated with discretion without necessarily implying a trade-off between flexibility and commitment. In particular, I make a substantial contribution on the puzzling issue of the optimality of interest-rate smoothing by showing that gradualism may enhance credibility as it contrasts the incentive to exploit employment and output gains deriving from inflation surprises.

The real effectiveness of monetary delegation in overcoming the problem of time inconsistency has been recently questioned. Jensen has shown that optimal policy can be credible under delegation only if reappointment costs are prohibitive. Conversely I make evident that, when delegation is not considered as an alternative, but rather as supplementary, to reputation and is conducive to reputation building for the central banker, the circumstances under which optimal monetary delegation can be credible need not be so extreme.

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