Credibility & Policy: Central Bank Independence & Conservative Banking, Slides of Banking and Finance

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Lecture 9

Central Bank Independence and Conservative Central Banking

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

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 = ( π - π e) + ε
• where π is inflation, π e^ is the expected rate of

inflation and ε is a random shock

Society’s Iso-Loss function

[ ( ) ]

2 2 2

L =^1 E π + b x − x

Time-consistent policy is given by

agents optimising

[ ( ) ]

[ ( )]

b x

E b x

L

L E b x

e

e

e

π

π π π ε π

π π π ε

2 2 2

1

But the CB/government optimises

[ ( ) ]

[ ( )]

ε

ε π

π

π π π ε π

π π π ε

b

x

b

b bx

plug bx

L b x

L b x

e

e

e

=

= −

=

= + − + − = ∂

∂

= + − + −

1

1

1

21 2 2 0

2 2 21

But this is not credible

2

2 2 1

1

1

1

σ σ ε

π ε

 

  



=

 

  



′ = −

b

b

x

The ‘Inflation Nutter’ Deflationary bias

x

π A B

C

C 1

C 2

C 3

ε>

ε=

ε<

A’ B’^ C’

Substitute CB preference result into

societies loss function

2 2 2

1

L x b ε x β

ε β

β β

Optimising with respect to β

( )

( ) 0 1

3

2 2 − =

= + ∂

∂ x b

L β β

σ β β

ε

Evidence - Inflation?

Central Bank Independence and average inflation rate 1971-95^ Chart 1

0

2

4

6

8

10

12

0 2 4 6 8 10

percent

Germany

Switzerland^ USA^

Japan Netherlands

Canada

Belgium

Denmark (^) France

UK

Italy

Growth Variability

Relative variability of growth 1971-95 and CB rank of Independence^ Chart 3

0

20

40

60

80

100

120

140

160

180

0 2 4 6 8 10

percent German

Switzerland

USA

Japan

Netherlands Canada

Belgium^ Denmark France

UK Italy

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