Policy credibility and alternative approaches to disinflation (original) (raw)

Monetary Policy Credibility and the Macroeconomy

We quantify the effects of monetary policy transparency and credibility on macroeco-nomic volatility in an estimated model of the Euro area economy. In our model, private agents are unable to distinguish between temporary shocks to the central bank's monetary policy rule and persistent shifts in the inflation target, and therefore use optimal filtering techniques to construct estimates of the future monetary policy stance. We find that the macroeconomic benefits of credibly announcing the current level of the time-varying inflation target are reasonably small as long as private agents correctly understand the stochastic processes governing the inflation target and the temporary policy shock. If, on the other hand, private agents overestimate the volatility of the inflation target, the overall gains of announcing the target can be substantial. We also show that the central bank can help private agents in their learning process by responding more aggressively to deviations of infl...

The ex ante credibility of disinflation policy and the cost of reducing inflation*

Journal of Macroeconomics, 2001

paper contains an empirical study of the effects of credibility on the cost of disirtflatJon. The analysis is based on a dataset composed of seventy-two disinflation episodes from 19 OECD countries. We measure the "'ex ante credibility" of a disinflation episode as the probability of a successful disinflation conditional on economic and polilScal factors known to private agents on the eve of the disinflation. Under a variety of empirical specifications we find that more credible disinflations are associated with smaller losses in aggregate output. *We thank seminar participants at the Federal Reserve Bank of Richrnond, the 1997 NBER Summer Monetary Economics Program, and two anonymous referees for valuable suggestions on an earlier draft of this paper.

Three Great American Disinflations

2007

This paper analyzes the role of transparency and credibility in accounting for the widely divergent macroeconomic effects of three episodes of deliberate monetary contraction: the post-Civil War deflation, the post-WWI deflation, and the Volcker disinflation. Using a dynamic general equilibrium model in which private agents use optimal filtering to infer the central bank's nominal anchor, we demonstrate that the salient features of these three historical episodes can be explained by differences in the design and transparency of monetary policy, even without any time variation in economic structure or model parameters. For a policy regime with relatively high credibility, our analysis highlights the benefits of a gradualist approach (as in the 1870s) rather than a sudden change in policy (as in 1920-21). In contrast, for a policy institution with relatively low credibility (such as the Federal Reserve in late 1980), an aggressive policy stance can play an important signalling role by making the policy shift more evident to private agents.

Does monetary policy transparency reduce disinflation costs?

The Manchester School, 2003

We examine the relationship between central bank transparency and the costs of disinflation. We provide a model where disinflation efforts imply a higher sacrifice ratio when the public is not fully convinced about the central bank's resolve to reduce inflation and show that information dissemination by the central bank can remedy this problem. To assess the empirical implications we estimate sacrifice ratios based on individual estimates of Phillips curves in 21 OECD economies. Using transparency indices pertaining to both the detail with which central banks publish forecasts and the means by which policy decisions are explained, we find that a higher degree of central bank transparency is associated with lower sacrifice ratios. This result is robust to alternative estimation methods and periods considered.

Inflation Targeting and Liquidity Traps under Endogenous Credibility

Journal of Monetary Economics

We derive policy implications for an inflation targeting central bank, who's credibility is endogenous and depends on its past ability to achieve its targets. We do this in a New Keynesian framework with heterogeneous agents and boundedly rational expectations. Our assumptions about expectation formations are more in line with expectations observed in survey data and laboratory experiments than the fairly restrictive rational expectations hypothesis. We find that the region of allowed policy parameters is strictly larger under heterogeneous expectations than under rational expectations. Furthermore, with theoretically optimal monetary policy, global stability of the fundamental steady state can be achieved, implying that the system always converges to the targets of the central bank. This result however no longer holds when the zero lower bound (ZLB) on the nominal interest rate is accounted for. Self-fulfilling deflationary spirals can then occur, even under optimal policy. The occurrence of these liquidity traps crucially depends on the credibility of the central bank. Deflationary spirals can be prevented with a high inflation target, aggressive monetary easing, or a more aggressive response to inflation.

Credibility in Monetary Policy

This essay examines credibility in monetary policy. In particular it follows Blinder's (2000) survey in focusing on why such credibility is important and the role that central bank transparency plays in determining it. It also considers what happens when credibility changes. It finds that credibility is particularly important for maintaining low and stable inflation through its effect on inflation expectations and that transparency's role involves influencing those expectations. Improving credibility may actually increase volatility unless central banks take the change into account and adjust their reaction functions accordingly.

A Credibility Proxy: Tracking US Monetary Developments

The B.E. Journal of Macroeconomics, 2012

We identify empirically the extent to which expectations are de-coupled from inflation, how well they are anchored in the long run, and at what level. This empirical measure serves as a proxy for credibility. We apply this methodology to US inflation from 1963 till today, as it incorporates periods for which credibility was known to be low as well as high. Following the narrative of a number of well documented incidents in the period of the Great Moderation, we check how well our measure captures both the evolution of credibility in US monetary history, as well as reactions to inflation scares.

Expectation, learning, and the costs of disinflation.pdf

The macroeconomic costs of disinflation are considered for the United States in a rational expectations macroeconometric model with sticky prices and imperfect information regarding monetary policy objectives. The analysis centers on simulation experiments using the Board's new quarterly macroeconometric model, FRB/US, within which are nested both expectations formation that is 'rational' (i.e., model consistent) and 'restricted-information rational' (i.e., where the information set is restricted to that captured by a small-scale VAR model). We characterize monetary policy as being governed by rules. Disinflations are represented by changes in the target inflation rate of a interest-rate reaction function. Two kinds of rules are considered: a version of the Taylor rule and the other being a more aggressive and richer specification estimated using data for the last 15 years. We assume agents are not fully cognizant of changes in the Fed's inflation target and must instead adjust their perceptions of the target according to a linear updating rule. Simulation results for sacrifice ratios are compared with results from other models and with econometric results and calculations reported in the literature.

Monetary Policy with Diverse Private Expectations

SSRN Electronic Journal, 2015

We study the impact of diverse beliefs on conduct of monetary policy. Individual belief is modeled by a state variable that defines an individual's perceived laws of motion. We use a New Keynesian Model that is solved with a quadratic approximation hence individual decisions are quadratic functions. Aggregation renders the belief distribution an aggregate state variable. Although the model has standard technology and policy shocks, diverse expectations change materially standard results about a smooth trade-off between inflation volatility and output volatility. Our main results are summed up as follows: (i) The policy space contains a curve of singularity which is a collection of policy parameters that divides the space into two sub-regions. Some trade-off between output and inflation volatilities exists within each region and some across regions. (ii) The singularity causes volatility of variables to be non monotone in policy parameters. Policymakers cannot assume a more aggressive policy will change outcomes in a predictable manner. (iii) When beliefs are diverse a central bank must also consider the volatility of individual consumption and the related volatility of financial markets. We show aggressive anti-inflation policy increases consumption volatility and aggressive output stabilization policy entails rising inflation volatility. Efficient central bank policy must therefore be moderate. (iv) High optimism about the future typically lowers aggregate output and increases inflation. This "stagflation" effect is stronger the stickier prices are. Policy response is muted since the effects of higher inflation and lower output on interest rates partially cancel each other. Effective policy requires targeting exuberance directly or its effects in asset markets. Central banks already do so with short term interventions. (v) The observed high serial correlation of 0.80 in policy shocks contributes greatly to market volatility and we show that a reduction in persistence of central bank's deviations from a fixed rule will contribute to stability. (vi) Belief dispersion is measured by cross sectional standard deviation of individual beliefs. An increased belief diversity is found to make policy coordination harder and results in lower aggregate output and lower rate of inflation. Bank policy can lower belief dispersion by being more transparent.

A measure for credibility: tracking US monetary developments

2008

A Measure for Credibility: Tracking US Monetary Developments* Our objective is to identify a way of checking empirically the extent to which expectations are de-coupled from inflation, how well they might be anchored in the long run, and at what level. This methodology allows us then to identify a measure for the degree of anchorness, and as anchored expectations are associated with credibility, this will serve as a proxy for credibility. We apply this methodology to the US history of inflation since 1963 and examine how well our measure tracks the periods for which credibility is known to be either low or high. Of particular interest to the validity of the measure is the start of the Great Moderation. Following the narrative of a number of well documented incidents in this period, we check how well our measure captures both the evolution of credibility in US monetary policy, as well as reactions to inflation scares.