Advanced Macroeconmic Theory
How might delegation to a conservative central banker help overcome the inflationary bias to monetary policy? Demonstrate this result formally or graphically. [8 Marks]
In much of the literature on Central Bank Independence CBI, independence is often not distinguished carefully from conservativeness. In fact, most of the legal indicators for CBI give a central bank a higher score if price stability is the (primary) objective of the central bank concerned, while it, of course, implies less goal independence. The reason for doing so is that in the theoretical set-up both independence and conservativeness matter for the inflation performance. We can exemplify this as follows.
It is assumed that policy-makers seek to minimize the following loss function, which represents the preferences of the society: Eqn 1
Where yt is output, y* denotes desired output and x is government's weight on output stabilization ( > 0). Output is driven by a simplified Lucas supply function:
Eqn 2
Where π is actual inflation, πe is expected inflation, and is a random shock with zero mean and a variance of . Policymakers minimize (Eqn 1) on a period by period basis, taking the inflation expectations as given. With rational expectations, inflation turns out to be:
Eqn 3
The first term at the right hand side of (Eqn 3) is the inflationary bias. A country with a high inflationary bias has a credibility problem, as economic subjects realize government's incentives for surprise inflation. The second term in (Eqn 3) reflects the degree to which stabilization of output shocks influence inflation.
Suppose now that a 'conservative' central banker is put in charge of monetary policy. Conservative means that the central banker is more inflation-averse than government. The loss function of the central banker can therefore be written as: Eqn4
Where, denotes the additional inflation aversion of the central banker. The preferences of the central
In much of the literature on Central Bank Independence CBI, independence is often not distinguished carefully from conservativeness. In fact, most of the legal indicators for CBI give a central bank a higher score if price stability is the (primary) objective of the central bank concerned, while it, of course, implies less goal independence. The reason for doing so is that in the theoretical set-up both independence and conservativeness matter for the inflation performance. We can exemplify this as follows.
It is assumed that policy-makers seek to minimize the following loss function, which represents the preferences of the society: Eqn 1
Where yt is output, y* denotes desired output and x is government's weight on output stabilization ( > 0). Output is driven by a simplified Lucas supply function:
Eqn 2
Where π is actual inflation, πe is expected inflation, and is a random shock with zero mean and a variance of . Policymakers minimize (Eqn 1) on a period by period basis, taking the inflation expectations as given. With rational expectations, inflation turns out to be:
Eqn 3
The first term at the right hand side of (Eqn 3) is the inflationary bias. A country with a high inflationary bias has a credibility problem, as economic subjects realize government's incentives for surprise inflation. The second term in (Eqn 3) reflects the degree to which stabilization of output shocks influence inflation.
Suppose now that a 'conservative' central banker is put in charge of monetary policy. Conservative means that the central banker is more inflation-averse than government. The loss function of the central banker can therefore be written as: Eqn4
Where, denotes the additional inflation aversion of the central banker. The preferences of the central