Anti-Inflationary Policies and the Issue of Credibility of Central Banks

1902 Words May 12th, 2011 8 Pages
Introduction

Anti-inflationary policies are the policies taken by the government to announce inflation target lowering it to zero, in the beginning of the year, which at that time is considered optimal. The government wants to keep the inflation level low in an economy. It is the continuous rise in the general price level of goods and services over a period of time in an economy. As we know inflation can cause serious social consequences, if it’s not perfectly anticipated, money as a measure of value or as a medium of exchange is undermined.

The issue of credibility

The announcement of the government of anti-inflation will form expectations and be embedded into contracts. Wage contracts are also signed in this period. In this
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With rational expectations inflation is: ………………………………

The first term on the right hand side is the ‘inflationary bias’ and the second term reflects to the degree to which stabilisation of output shocks influence inflation.

If a conservative central banker is charge of the monetary policy the loss function would be

……………………………………………………….

…..is additional inflation aversion of the central banker.

According to Eijffinger and Hoeberichts ( 1998), the money supply can be modelled as:

…………………………………

…..is the degree of central bank independence.

So, after minimising government’s loss function, with rational expectations, inflation will be depicted

as………………………………….

Comparing the inflation level it can be seen that the inflationary bias is lower for positive values of

….. and ……

It does show that lower level of inflation will be achieved by delegating monetary policy to a conservative and independent central bank. But if the central banker and the government has the same inflation aversion, (ε=0) the independence does not matter and in the same way, if the central bank is fully controlled by the government, (ϒ=0) the conservativeness does not matter, unless it is the optimal combination of ϒ and ε.

However, McCallum (1995) criticised this solution of reducing inflation bias. He argued that delegation barely relocates the time inconsistency problem rather than resolving it, since the government can still…