American Economic Association



Credibility of Optimal Monetary Delegation
Author(s): Henrik Jensen
Source: The American ...
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                    Credibility OptimalMonetaryDelegation

                                              By HENRIK JENS...
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VOL. 87 NO. 5            JENSEN: CREDIBILITY OPTIMALMONETARY
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for the gov...
VOL. 87 NO. 5             JENSEN: CREDIBILITY OPTIMALMONETARY
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time, it would be mor...
VOL. 87 NO. 5             JENSEN: CREDIBILITY OPTIMALMONETARY
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If the government is su...
VOL. 87 NO. 5        JENSEN: CREDIBILITY OPTIMALMONETARY
                                        OF              DELEGATIO...
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Lohmann, Susanne. "Optimal Com...
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Credibility Of Optimal Monetary Delegation

  1. 1. American Economic Association Credibility of Optimal Monetary Delegation Author(s): Henrik Jensen Source: The American Economic Review, Vol. 87, No. 5 (Dec., 1997), pp. 911-920 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/2951332 Accessed: 20/12/2009 11:19 Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/action/showPublisher?publisherCode=aea. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org. American Economic Association is collaborating with JSTOR to digitize, preserve and extend access to The American Economic Review. http://www.jstor.org
  2. 2. of Credibility OptimalMonetaryDelegation By HENRIK JENSEN* When optimal monetary policy is subject to a credibility problem, it is often argued that the government should appoint a central banker whose incentives differ from the government's. I argue, however, that such delegation does not overcome credibilityproblems given that delegation is discretionary and without costs. "Reappointment costs" of delegation are shown to improve suboptimal outcomes, but credibility of optimal monetary policy turns out to be worsened. At best, delegation therefore has no effects on credibility, but only if reappoint- ment has no costs. (JEL E42, E58) When monetary policy is subject to dy- banker (CB), and stipulates conditions for namic inconsistencies, policy outcomes are policy so as to avoid dynamic inconsistencies.' suboptimal if the government cannot precom- These theories therefore have indisputable, mit (Finn E. Kydland and EdwardC. Prescott, well-timed normative relevance, given the 1977; Guillermo A. Calvo, 1978): Ex ante op- need for new monetary institutions in, e.g., timal plans are not credible because private eastern Europe, the former Soviet Union, and sector agents recognize the government's in- within the upcoming monetary union in Eu- centive to reoptimize later. Expectations will rope. Also, they have been valuable in the un- then be formed in anticipation of this ex post derstanding of various existing monetary incentive, thereby bringing the economy off institutional arrangements.2 the optimal path. A simple and powerful case However, despite these virtues I am not con- in point is the policy game due to Robert J. vinced that the theories provide a satisfying Barro and David B. Gordon (1983a,b), resolution of the dynamic inconsistency prob- wherein the government has the incentive to lem they purportto remedy. If the problem is boost output above the "naturalrate" through present when the government performs mon- surprisemonetaryexpansions. In a rationalex- etary policy, it remains when policy is dele- pectations equilibrium,however, output is un- gated: If the problem was caused by an affected by the incentive, but an inflation bias incentive to create surprise inflation in the prevails. The optimal plan-where the bias is absent-is dynamically inconsistent, and a crucial issue for monetary policy-making is ' Rogoff (1985), though, considered merely institu- therefore to overcome such inconsistencies. tions that could improvethe dynamically consistent policy Inspired by the original contribution of (by delegation to a "conservative" CB who is more in- Kenneth Rogoff (1985), this has recently re- flation averse than the government; see Robert P. Flood ceived renewed interest in theories on dele- and P. Isard [1989] and Susanne Lohmann [1992] for ex- tensions). Recent contributions,however, focus on the in- gation of monetary policy. The idea is that the troduction of incentive schemes or policy targets in order government hands over the sole responsibility to remove dynamic inconsistencies and obtain optimal of policy conduct to an independent central policy; see, e.g., Torsten Persson and Guido Tabellini (1993), Carl E. Walsh (1995a, b), Michele Fratianniet al. (1997), and Lars E. 0. Svensson (1997). 2 The independence of the GermanBundesbank and its * Institute of Economics, University of Copenhagen, explicit guidelines for money growth is one prominentex- Studiestraede 6, DK-1455 Copenhagen K, Denmark. I ample of monetary delegation. The 1989 central bank thank David D. VanHoose, one anonymous referee, and reform in New Zealand, whereby the governor's employ- participants of the European Economic Association's ment conditions are contingent on the success of policy, 1996 Istanbul meeting for several helpful comments and is anotherwidely cited example; see Persson and Tabellini suggestions to an earlier version of the paper. I take re- (1993), Stanley Fischer (1995), and Walsh (1995b) for sponsibility for any errors or omissions. discussions. 911
  3. 3. 912 THE AMERICANECONOMICREVIEW DECEMBER 1997 former case, it prevails in the latter due to an confirm the assertion that delegation does not incentive to create conditions for monetary resolve dynamic inconsistencies given that policy consistent with surprise expansions. In delegation is discretionary and without costs: the terminology of Bennett T. McCallum The outcomes of the policy game, in the case (1995), delegation does not resolve the dy- where the government cannot precommit, are namic inconsistency, "it merely relocates it" the same no matter whether the government (p. 210). My fundamentalcritique is therefore performs monetary policy itself or delegates. in concert with what he labels the "second fal- Moreover, the condition for the success of the lacy" of theories on delegation. Basically, precommitmenttechnology is not changed by they do not explicitly answer why delegation delegation (the technology rests on conven- of monetary policy is more credible than mon- tional tit-for-tat punishment strategies origi- etary policy in itself. nally put forward in these games by Barro and Absent any explicit answers, however, the Gordon, 1983b). These results indicate that if theories have an implicit one saying that optimal policy is credible when the govern- monetary delegation is made at the "'consti- ment chooses monetary policy directly, it is tutional" level and thus cannot be altered as also credible under delegation. On the other easily as monetary policy. Hence, as noted hand, if the government has no credibility by Fischer (1995) in his survey, there is an when performingpolicy itself, delegation pro- implicit assumption that it is costly to change vides no gains. the conditions for monetary policy.3 But These results are not surprisingwhen dele- even so, resolution of the dynamic consis- gation can be changed withoutcosts. I therefore tency is achieved by definition: It is assumed give credence to the idea that it is costly to that constitutions always bind or that costs change monetarydelegation (at least relativeto of changing them are prohibitive-a formal monetarypolicy), and assume that the govern- precommitment technology is never pres- ment incurs some "reappointmentcosts" of ented. But McCallum (1995) shows that changing the conditions guiding policy.' It is constitutions need not bind: No constitu- then found that delegation to some extent re- tional amendment has taken the United duces the inefficiency associated with the dy- States off of the metallic standard, even namic inconsistency. However, only in the though it in practice has been abandoned a special case where costs are all that matterfor long time ago. Moreover, the guidelines of the government is the dynamic inconsistency the often quoted New Zealand 1989 reform resolved completely. Credibility of optimal have already been changed more than once monetarypolicy is again examined throughthe (Walsh, 1995b), revealing that costs need precommitment technology, and it turns out not be prohibitive. The purpose of this paper is to reconsider the question of monetarydelegation in a model and Kenneth L. Judd (1987). Surprisingly, it is usually where the choice of delegation is a part of the neglected in policy games literature.One exception is Juan strategic interaction, and where a formal pre- J. Dolado et al. ( 1994) in a context of internationalpolicy commitment technology supporting the opti- cooperation. 5In Lohmann (1992) the government incurs a fixed mal policy plan is considered explicitly.4 I then cost if it overrides the central banker, and the size of the cost is assumed to be a choice variable of the government. Although the choice is nontrivial in her stochastic frame- work with Rogoff (1985) conservativeness, it would be I so in my case of optimal monetary delegation: The cost Walsh ( 1995a), for example, mentions that a referee raised the issue that the government could always renege should just be prohibitive, and credibility would be at- on its initially chosen form of monetary delegation (foot- tained by definition. But it is questionable that a govern- note 5 p. 152). With reference to institutional features of ment can choose the costs of its actions, and I therefore the United States, Walsh then remarksthat " (...) there are assume costs to be exogenously given (if costs could be agencies of government that are designed to make such chosen freely it would seem a lot easier if the government circumventions more difficult." conducted monetarypolicy by itself, and then chose a pro- 4 Delegation as a strategic choice variable is standard hibitive cost to come in effect if it deviated from the op- in the industrialorganization literatureon the structureof timal policy plan). The present analysis thus differs the firm, cf. John Vickers (1985) and Chaim Fershtman markedly from hers.
  4. 4. VOL. 87 NO. 5 JENSEN: CREDIBILITY OPTIMALMONETARY OF DELEGATION 913 that costs make optimal monetary policy less Kydland and Prescott (1977) and Barro and credible (technically speaking, the set of dis- Gordon( 1983a, b). At time t, in a nonstochastic count factors securing that the condition for economy, (log) output,yt, is given by:6 credibilityis satisfiedshrinkswhen costs matter more). As the success of the technology rests (1) y, = a(x, -r), a > 0, on the deterrentforce of punishmentsinvolving a reversion to the no-commitmentsolution, the where 1r, and 7redenote actual and expected intuitionfor this result is straightforward: Since inflation, respectively. A governmentconducts costs improve this solution, the threat embed- monetary policy in each period with the aim ded in reversion becomes less deterrent. of attainingcertain targetvalues for outputand Explicit costs thus have pros and cons for inflation. For simplicity, it is assumed to con- monetary delegation. The outcomes without trol inflation directly. When performingpolicy commitmentwill indeed be improved,but a dy- at t, it takes current inflation expectations as namic inconsistency still prevails. Therefore,a given (due to nominal contracting) and mini- governmentwhich suffers a credibilityproblem mizes Es =t 3s - tL, subject to ( 1), where Lt is will gain by monetary delegation, and as such the per-period loss function and 0 < /3 < 1 is our model supportsthe widespread notion that a discount factor. The per-periodloss function more CB independence can be a way to lower is: inflation-a view confirmed by empirical evi- dence (Vittorio Grilli et al., 1991; Alberto (2) Lt = X(Yt_y*)2 + X29 A > O, Alesina and Lawrence H. Summers, 1993; Fischer, 1995). On the other hand, optimal where y* and zero, respectively, are the so- monetarypolicy does not become credible; in cially desirable rates of output and inflation. fact, the chances of attaining credibility de- As is usual, we shall assume that y* > 0, crease. Hence, the benefits of monetary dele- i.e., that the natural rate of zero is considered gation seem somewhat exaggerated in the as being too low by the government (disre- newer literature, even when its implicit as- garding a nonzero inflation target is imma- sumption about costs of changing delegation is terial). It is straightforward to show that if taken for granted. the government cannot precommit to a par- Section I considers the conventional mone- ticular policy before expectations are tary policy game featuring a dynamic incon- formed, the no-commitment solution is char- sistency, and the particular precommitment acterized by yNC = 0 and rTC = Xay*. This technology for credibility of optimal policy is is inefficient as output is below y * and infla- defined. Section II contains the model and tion is positive. Although it is immediate main results on discretionary monetary dele- from (1) that in any rational expectations gation with reappointment costs. Section III equilibrium, output will be suboptimal, there concludes. is no immediate reason why society should live with inflation. But the appearance of an inflation bias stems from the familiar dy- I. Credibility of Optimal Monetary Policy: namic inconsistency problem of optimal The Conventional Model of Discretionary monetary policy. To see this, assume that Policy-making precommitment is possible such that an- nouncements about a policy is believed and adhered to. Then, the following precommit- This section briefly presents the original ment outcomes turn out: Y' = 0, ttPR -, = model of discretionary monetary policy of which clearly improve the no-commitment solution. But given w, = 0, it is not optimal 6 It may seem peculiarto consider a deterministicsetup, as much of the early literatureon monetary delegation in of delegation we consider is related to recent literature the Rogoff (1985) vein dealt with the trade-off between where this trade-off does not exist. The results are there- reduced inflation and loss of flexibility. However, the form fore independent of stochastic elements.
  5. 5. 914 THE AMERICANECONOMICREVIEW DECEMBER 1997 for the government to deliver 7r = 0; instead In order to examine whether (3) supports op- it deviates and conducts policy so as to ob- timal monetary policy as Nash equilibriumbe- tain yf' = (Xca2/A)y*, T = (Xa/A)y*, havior at any time t, one compares the where A -1 + Xa2 > 1. Hence, it surprises government's loss from adhering to the strat- the private sector and obtains output above egy with the case where it deviates. Given that the natural rate and inflation below the level the future from t + 2 and onwards is the same in the no-commitment solution. But if the under any strategy choice, it follows that (3) private sector believes that the government supports optimal policy if L' - L optimizes after expectations are formed, it 3(LNc -L") where the left-hand side is will never set wr' = 0, but instead set r = the temptation to deviate at t, and the right- Xay* through which we are back in the no- hand side is the discounted punishment of de- commitment solution. viation at t. Inserting the outcomes under the The crucial word in the last sentence is three possible events into the loss function, "if ": Given that the model is one of an infi- this inequality can be written as a condition nite horizon, it is possible for the government defining a minimal value of,3: to obtain credibility of the optimal policy. This was demonstrated by Barro and Gordon (1983b) applying simple and well-known folk (4) la 2 3A < I. theorem arguments from the theories on re- peated games: If the private sector adopts Hence, if the government cares sufficiently some punishment scheme whenever deviation about the future, i.e., if ,3 is sufficiently high, from optimal policy is observed, the precom- the punishment deters deviation, and (3) se- mitment solution is a perfect Nash equilibrium cures that optimal monetarypolicy is a perfect given that the government does not discount Nash equilibrium. We then say that it is cred- the future too much. More specific, Barro and ible. If, on the other hand, (4) is not satisfied, Gordon assumed that the private sector uses optimal monetary policy cannot be credible, tit-for-tat strategies by which it reverts to ex- and the economy must live with the inflation pectations of the no-commitment solution for bias. (It is clear that if /6 < 6, some wr,,0 < one period whenever the government fails to r,t < rNC can be supported, cf. Barro and act according to the precommitmentsolution.7 Gordon, 1983b. But for the present purposes, This scheme amounts to the following speci- the main issue is that the optimal inflation rate fication of policy and expectations: would not be sustainable.) (3) Government plays: w, = rt. II. A Modelof Discretionary Delegationwith Reappointment Costs Private sector plays: Credibility problems of optimal monetary 7re = y if -l = eI; policy have lead to the suggestion of delegat- ing monetary policy to independent CBs. The ,7re = Aay * if X,t- I Xe_1 role of the government is then one of deter- mining the institutional framework for mone- tary policy-making, whereas the CB conducts actual policy. Recent contributionsof Persson and Tabellini (1993) and Walsh (1995a) take 7 The focus on these simple punishment strategies is motivated exactly by their simplicity. Punishments in- a contract approachwhere the government in- volving reversion to the no-commitment solution for a troduces an inflation-dependent payment longer duration could be suggested without changing the scheme for the CB. I focus on this approach results qualitatively. It is important, though, that the du- because it has been the most predominant in ration is invariantwith respect to monetaryregime. Hence, recent research and since it renders the issue the analysis is in accordance with Nancy L. Stokey (1989), who considers the durationof punishments as an of supply-shock stabilization irrelevant (see " (...) exogenous parameterdescribing a characteristicof footnote 6). But in the present deterministic households" (p. 138). setting, all forms of delegation considered in
  6. 6. VOL. 87 NO. 5 JENSEN: CREDIBILITY OPTIMALMONETARY OF DELEGATION 915 the literature yield the same outcomes (see formity with the examples provided in the Svensson, 1997 for a survey), so the results introductionto this paper,however, these costs would be qualitatively unchanged had the fo- are not assumed to be prohibitive. cus been on other forms. The sequence of events is as follows. In the Under the contract approach, the CB is as- beginning of each period, the government an- sumed to share the government's loss func- nounces the conditions for policy-making, i.e., tion, but is "fined" if inflation exceeds zero. it appoints a CB and presents it with a contract Thus, the CB's per-period loss function, L', fl. Subsequently, expectations are formed. is: Lb = -(y _ y*)2 + Ir2 + 2f,,r, where2f, After observing these expectations, the gov- is the magnitude of the "fine." Now, when ernmentis able to change actual conditions for monetary policy is delegated, it is straightfor- monetary policy-making. That is, it can revise ward to show thatft = Xay* secures that the the contract and implement somef . After that, precommitment solution is achieved. But as the CB performs monetary policy in accor- argued, delegation theories can be thought of dance with these-potentially different- as incomplete in the sense that the decision conditions. If f, * fl, the CB is said to be about delegation is not considered as a part of reappointed. Reappointment,however, entails the strategic interaction. Instead, the theories some cost. To model this, I introduce a quad- characterize what an optimal institution for ratic cost term in the government's loss func- policy should look like, and implicitly assume tion, and the amended function therefore that the institution always binds. Although reads: such a characterizationis of considerable in- terest, the approach sidesteps a central issue raised by the literature on dynamic inconsis- (5) L, = X(yt _ y*)2 + 2 tency of economic policy, namely whether an optimal policy plan is credible. + (P(f _ fa )2, >O I think that if the government can appoint a CB facing particular incentive mechanisms where the parameterfo is the weight by which (here some value offt), it can also fire the CB, reappointment costs are disliked relative to or, less drastic, revise the conditions under macroeconomic variables. which it operates (i.e., changeft) before mon- Note that this move structurepresumes that etary policy is actually conducted. In other a change in monetary conditions can be im- words, it seems realistic to assume that the plemented within a period without affecting government has some discretion with respect inflation expectations at all. Clearly, if the pro- to monetary delegation. The question is then cess of changing monetary conditions takes to what extent optimal delegation is a more credible operation than the conduct of optimal monetary policy in itself. To address this, I the conditions securing credibility with the case of no del- incorporatethe decision on delegation explic- egation. Absence of costs, however, tentatively suggests itly into the policy game in a manner that al- that the conditions are identical, thus confirming (in a dif- lows one to take into account the implicit ferent setting) my claim that delegation then plays no role for credibility. The former analysis, on the other hand, assumption of the literature, namely that does perform an explicit comparison of conditions for changes in monetary delegation are costly rel- credibility in a private information setting along the lines ative to changes in monetary policy.8 In con- of Matthew B. Canzoneri (1985): Under delegation, the information problem is resolved and reputational forces work more effectively. Delegation thus improves credi- bility of monetary policy and as such it opposes my main result. But enhanced credibility is in my opinion not a 8 After completing the first version of this paper, I have result of delegation per se, but merely because delegation become aware of two papers, Berthold Herrendorf( 1996) changes are defined to be publicly observed and adhered and Ali al-Nowaihi and Paul Levine (1996), who also to (the government, for example, cannot secretly change consider models where delegation can be changed; in both delegation, although it would be optimal). Hence, en- instances, however, at no cost. The latter analysis finds, in hanced credibility also arises without delegation if the an incomplete information setup like Barro ( 1986), that government by definition truthfullypublicized its planned optimal delegation may be credible, but does not compare inflation rate and adhered to it.
  7. 7. 916 THE AMERICANECONOMICREVIEW DECEMBER 1997 time, it would be more naturalto assume that When choosing actual conditions for monetary expectations to at least some extent adjust to policy, the government must take its prior an- the change. But in orderto take accountof this, nouncements and inflation expectations as the basic model should be altered so as to al- given when minimizing I 6,s-T'L,with re- low for, e.g., staggered nominal adjustment spect tof, subject to (1) and (6). The optimal and/or a larger number of periods before a choice turns out to be: change in monetaryconditions becomes effec- tive. This obviously complicates analytical matters immensely (for example, the repeated (7) f oA game turnsinto a dynamic one wherein the no- 1+ soA' commitment solution may not be unique for this class of games; Ben Lockwood, 1996). Only when the government' s only concern is But as long as some part of inflation expecta- reappointment costs, will announcements be tions can be taken as given at the "reappoint- fulfilled (i.e., when fo -+ oo,f, = if). At the ment stage" of the game, the qualitativenature opposite extreme where costs are negligible, of the ensuing results would remain. More- it is, not surprisingly, optimal for the gov- over, the degree to which inflation expecta- ernment to present the CB with a contract tions cannot be treated as given can be securing that monetary policy will be con- interpreted as one determinant of o: The ducted in accordance with the preferences of higher p, the more difficult it will be to change society (f, = 0 indeed secures that L,' = monetary conditions within the period for Lt 0). For intermediate values of ~o,how- given expectations. ever, the government weighs reappointment By (5), large discrepancies between actual costs against the net gains of surprise infla- and announced conditions have greater costs tion, and some degree of reappointment will than small ones. This is, of course, not con- be tolerated in the sense that actual monetary sistent with the idea that one is considering, conditions will be looser than announced e.g., the "menu costs" of just writing a new (f, < if). The private sector forms inflation contract with the CB (for which the issue of expectations based on (6) and (7). Inserting credibility is resolved by definition if the cost the latter into the former and taking expec- is sufficiently high). But if the parameterf is tations yields: interpreted as a broad proxy for a more com- plicated system of monetary regulations, it seems natural that a small change is less (8) r = Aay* _ oA costly to enact than a large one (e.g., in terms of administrative costs). In any case, the cen- tral aspect is that there are costs associated Finally, the optimal announcement is deter- with institutional changes that are absent in mined. The government chooses Jf in orderto monetary policy changes (see Lohmann, minimize L, subject to (6), (7), and (8), i.e., 1992 for more examples of the nature of such underperfect knowledge about the ensuing be- costs). This is in full accordance with the im- havior of the private sector, itself, and the CB. plicit assumption of the literature on mone- The solution is: tary delegation. The model is now solved, and I begin with the case of no commitment. The CB minimizes A(1 + SoA)Xay* (9) 1+ soA 2 5%=, 6fs-'Lb subject to (1), taking inflation expectations, ire, and actual conditions for policy-making, f,, as given (the announced Note that the announcement is "too low" in contract ft is, of course, irrelevant at this orderto imply the optimal inflation rate, as this stage). From the first-ordercondition, one ob- would require ft = ( 1 + oA) Xay*/(oA), cf. tains the following reaction function: (8). But then, the government would suffer too big a loss in terms of reappointmentcosts, (6) = wr, A-'(Xa2ire + Xay* f) and it would clearly be better to reduce ft
  8. 8. VOL. 87 NO. 5 JENSEN: CREDIBILITY OPTIMALMONETARY OF DELEGATION 917 somewhat, as this would entail a first-order yDD = a2y gain, while the associated increase in inflation (11) YtDD = A(1 + poA) would only be a second-orderloss. By reverse argumentation, it follows that Jf is chosen higher than what would induce the inflation DD = Xay* rate to match the one in the game without del- A(1 + WA)' egation (this would require fl = 0): The gov- ernment would then suffer too much in terms of inflation, and would therefore increase fl faDD fDD = ,oAXay somewhat, as the gain in terms of lower infla- = ay* f 1DI+ ~oA tion is of higher order than the loss in terms of reappointment costs. As a result, the an- Through deviation, the government induces nouncement is chosen so as to imply an infla- the CB to engineer surprise inflation by loos- tion rate between the optimal one and the ening conditionsfor monetary policy (ftD < one of the no-commitment solution without Xay*). In consequence, output is above the delegation. naturalrate, and inflation will be lower than in This is clarified by a combination of (1), the case of no commitment. (6), (7), (8), and (9), which provides the One can now examine credibility of optimal equilibriumoutcomes when no commitment is monetary delegation, and again by examining possible: the precommitment technology where the pri- vate sector punishes deviation by a one-period yCD = 0; ND _ Xay* reversion to expectations given by the (10) 1r+VC no-commitment solution. The following strat- egy combinations are therefore considered (one need not explicitly specify what happens ,NCD_ A(1 + pA)Xay* if the government deviates by fl * Xay*; such faNCD 1+5oA2 behavior can be ruled out through a reversion to the no-commitment solution for any value of 63): oA 1 + oA2 2 (12) Governmentplays: fCD 5A2Xay* Jt =f = Xay* if rt- I=rt; Examining (10), one finds that delegation does reduce the model's inflation bias. It does {a _ NCD ft t-J f=VCD Jt -Jt not, however, remove the bias unless fo is in- finite. For later reference, it should be noted if wt_ I 1e that the government's loss, L NCD decreases with o-partly because of the smaller infla- Private sector plays: tion bias, but also due to a smaller discrepancy between fa NCD and fNCD 7re = if 7rt_ I =re 1r-; Now, as seen previously, optimal monetary delegation is f = Xay*, and the presence of e NCD e lr t=7 lt if 7rt-* r wt -I - reappointment costs thus requires that ft = Xay* as well. The outcomes for output and inflation will then mimic the precommitment By the arguments of Section I, it follows that solution under no delegation. Since I want to (12) supports optimal monetary delegation as D determine the condition for the credibility of a perfectNash equilibriumif LPR - LDD this outcome, deviation outcomes must be /3(L NRCD-L PR 1). This can be rewritten as: found. Minimization of Lt with respect to f, subject to (6), taking ft = Xay* and irt = 0 as given, yields deviation outcomes as: (13) o 1+'A2<1. <
  9. 9. 918 THE AMERICANECONOMICREVIEW DECEMBER 1997 If the government is sufficiently patient, opti- gument of the literaturewhich seems to state mal monetary delegation will be credible. The that such costs are what makes delegation to following corollary follows immediately by independent CBs more credible than if mon- comparison of (13) and (4): etary policy were controlled directly by the government. When credibility is understoodas (14) lim/p)=_A. the ability to carry out the optimal policy, this o argument is false. The intuition is that the punishment follow- When reappointment costs play no role, the ing a deviation at t, Lt - Lt+ I, becomes condition for credibility of optimal monetary weaker the higher so Since Lt+ I is indepen- is. policy is not changed by monetary delegation. dent of Ip, this follows as LtNi'is a decreasing Whether the government conducts monetary function of ~o,cf. above. Hence, the fact that policy itself or delegates policy-making to a higher costs of reappointmentimprove the no- CB of its own choice has no impact whatso- commitment solution, is a mixed blessing as it ever on the basic issues of credibility: The CB becomes relatively more profitable to deviate will always be chosen so as to match the in- from the optimal solution. centives of society. As a consequence, the no- This line of reasoning, however, must be commitment, precommitment, and deviation balanced with the fact that the temptation to solutions are identical to the ones in the model deviate, LR- Lt also decreases with o. D, where monetary policy was the direct choice Due to Lt'R"s independence of ~o,this happens of the government. since LtDD increases. But even though the But as mentioned previously, delegation is temptation to deviate thus becomes weaker, it in the literatureimplicitly assumed to be more never counteractsthe implications of a weaker costly to change thanmonetarypolicy as such; punishment. This is because the increase in the remainderI therefore consider the case in LtD is of relatively low magnitude since it of o > 0. Now, the presence of such costs did results from several opposing factors. In fact, have a beneficial influence on the inflationbias both irf'0 and the discrepancy between ft0D in the no-commitment solution. But as the ul- and ftD decrease with fo and thereby contrib- timate goal of the design of monetary institu- ute to a fall in LDD; the associatedreduction tions should be to overcome potential in y', however,has sufficient adverseimpact credibility problems of optimal monetary pol- so as to cause LDD to increase.But the mag- icy, it is of relevance to compare the condition nitudewill be moderate compared the de- to for credibility of optimal monetary delegation crease in LNCD. when costs are present, with the one where it is not. This is done through the following III. Concluding Comments proposition: This paperconsidered meritsof mone- the PROPOSITION: For all p > 0, AD(fo) > / tarydelegationas a meansof overcoming dy- and O/D(so)/&s > 0. namicinconsistencies a simplepolicygame. in In contrastwith most recentanalyseson the PROOF: subject,I explicitlyincorporate delegation the From (13) it follows that O/ (so)/19p choice into the strategicinteraction, then and Xa2/(1 + pA)2 > 0. Using (14) it readily arriveat conclusionswhich qualify those of follows that la (( ) > /3for all f7 > 0. the existingliteraturewheredelegation con- is sidered as a way of escaping dynamic Hence, the minimum requirement for the inconsistencies. patience of the government becomes stricter The standard modelis extendedso as to ac- when there are costs of reappointmentin the countforcosts of changing delegation not (but delegation game. In other words, credibility of monetary policy). Thisaccommodates wide- a optimal monetary policy will be harderto sus- spreadimplicitassumption standard of mod- tain the more important reappointment costs els. It is then found that the more important are. This result runs against the implicit ar- such reappointment costs are, the betterare
  10. 10. VOL. 87 NO. 5 JENSEN: CREDIBILITY OPTIMALMONETARY OF DELEGATION 919 economic outcomes in absence of precommit- . "Rules, Discretion and Reputationin ment in comparison with the case without del- a Model of Monetary Policy." Journal of egation. Hence, monetarydelegation alleviates Monetary Economics, July 1983b, 12(1), the dynamic inconsistency but, on the other pp. 101 -21. hand, never removes it. More importantly, it Calvo,Guillermo "On the Time Consistency A. is shown that reappointmentcosts tighten the of Optimal Policy in a Monetary Econ- condition securing that optimal policy can be omy." Econometrica, November 1978, achieved through the particular precommit- 46(6), pp. 1411-28. ment technology under consideration. Canzoneri, Matthew B. "Monetary Policy Although the identification of optimal mon- Games and the Role of Private Informa- etary delegation-as it has been achieved in tion." American Economic Review, Decem- recent literature-is of considerable interest, I ber 1985, 75(5), pp. 1056-70. therefore feel that credible implementation of Dolado,Juan J.; Griffiths,Mark and Padilla,A. such a "policy package" has received too lit- Jorge. "Delegation in International Mone- tle attention. The present analysis is a first at- tary Policy Games." European Economic tempt to shed light on the issue and it provides Review, May 1994, 38(5), pp. 1057-69. a somewhat negative view on monetary dele- Fershtman, Chaimand Judd,KennethL. "Equi- gation as a way of ovelcoming dynamic in- librium Incentives in Oligopoly." American consistencies. Although the results are by no Economic Review, December 1987, 77(5), means an exhaustive account of the issue, they pp. 927-40. suggest that recent emphasis on delegation has Fischer,Stanley."Modem Approaches to Cen- diverted attention away from the question of tral Banking," in Forrest Capie, Stanley real importance: Why do dynamic incon- Fischer, Charles Goodhart, and Norbert sistencies exist? In the conventional model Schnadt, eds., Thefuture of central banking. presented here, they arise due to output inef- Cambridge: Cambridge University Press, ficiencies, and the crucial matter is thus to re- 1995, pp. 262-308. move inefficiencies through structuralpolicy Flood,RobertP. andIsard,P. "Monetary Policy (possible over time). The relationships be- Strategies." International Monetary Fund tween dynamic inconsistencies and structural Staff Papers, September 1989, 36(3), pp. policies should therefore receive much more 612-32. attention in future research. Fratianni, Michele; Hagen,Jurgenand Wailer, von Christopher "CentralBanking as a Political J. REFERENCES Principal-Agent Problem." Economic In- quiry, April 1997, 35(2), pp. 378-93. Alesina, Alberto and Summers, Lawrence H. Grilli, Vittorio; Masciandaro, Donato and "Central Bank Independence and Macro- Tabellini, Guido."Political and MonetaryIn- economic Performance:Some Comparative stitutions and Public Financial Policies in Evidence." Journal of Money, Credit, and the IndustrialCountries." Economic Policy, Banking, May 1993, 25(2), pp. 151-62. October 1991, 6(2), pp. 341-92. Ali al-Nowaihi, and Levine,Paul. "Independent Herrendorf, Berthold."Inflation Targeting as a but Accountable: Walsh Contracts and the Substitute for Precommitment." Mimeo, Credibility Problem." Global Economic In- University of Warwick, 1996. stitutions Working Paper Series No. 11, Kydland, Finn E. and Prescott, Edward C. May 1996. "Rules Rather than Discretion: The Incon- Barro, Robert J. "Reputation in a Model of sistency of Optimal Plans." Journal of Po- Monetary Policy with Incomplete Informa- litical Economy, June 1977, 85(3), pp. tion." Journal of Monetary Economics, 473-91. January 1986, 17(1), pp. 3-20. Lockwood, Ben. "Uniqueness of Markov- Barro,RobertJ. and Gordon,DavidB. "A Pos- Perfect Equilibriumin Infinite-TimeAffine- itive Theory of MonetaryPolicy in a Natural QuadraticDifferential Games." Journal of Rate Model." Journal of Political Econ- Economic Dynamics and Control, May omy, August 1983a, 91(4), pp. 589-610. 1996, 20(5), pp. 751-66.
  11. 11. 920 THE AMERICANECONOMICREVIEW DECEMBER 1997 Lohmann, Susanne. "Optimal Commitment in May 1989 (Papers and Proceedings), Monetary Policy: Credibility versus Flexi- 79(2), pp. 134-39. bility." American Economic Review, March Svensson,Lars E. 0. "Optimal Inflation Tar- 1992, 82(1), pp. 273-86. gets, 'Conservative' Central Banks, and McCallum, Bennett T. "Two Fallacies Concern- Linear Inflation Contracts." American Eco- ing Central-Bank Independence." Ameri- nomic Review, March 1997,87(1), pp. 98- can Economic Review, May 1995 (Papers 114. and Proceedings), 85(2), pp. 207-11. Vickers,John. "Delegation and the Theory of Persson,Torstenand Tabellini,Guido."Design- the Firm." Economic Journal, Supplement ing Institutions for Monetary Stability." 1985, 95, pp. 138-47. Carnegie-Rochester Conference Series on Walsh, Carl E. "Optimal Contracts for Inde- Public Policy, December 1993, 39, pp. 53- pendent Central Bankers." American Eco- 84. nomic Review, March 1995a, 85(1), pp. Rogoff, Kenneth. "The Optimal Degree of 150-67. Commitment to a Monetary Target." Quar- . "Is New Zealand's Reserve Bank Act terly Journal of Economics, November of 1989 an Optimal Central Bank Con- 1985, 100(4), pp. 1169-89. tract?" Journal of Money, Credit, and Stokey, Nancy L. "Reputation and Time Con- Banking, November 1995b, Part 1, 27(4), sistency." American Economic Review, pp. 1179-91.

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