Academic journal article Federal Reserve Bank of Minneapolis Quarterly Review

How Severe Is the Time-Inconsistency Problem in Monetary Policy?

Academic journal article Federal Reserve Bank of Minneapolis Quarterly Review

How Severe Is the Time-Inconsistency Problem in Monetary Policy?

Article excerpt


This study analyzes two monetary economies, a cash-credit good model and a limited-participation model. In these models, monetary policy is made by a benevolent policymaker who cannot commit to future policies. The study defines and analyzes Markov equilibrium in these economies and shows that there is no time-inconsistency problem for a wide range of parameter values. The study originally appeared in a book, Advances in Economics and Econometrics: Theory and Applications [c] 2003 by Cambridge University Press.

The history of inflation in the United States and other countries has occasionally been quite bad. Are the bad experiences the consequence of policy errors? Or does the problem lie with the nature of monetary institutions? The second possibility has been explored in a long literature, which starts at least with the work of Kydland and Prescott (1977) and Barro and Gordon (1983). This study seeks to make a contribution to that literature.

The Kydland-Prescott and Barro-Gordon literature focuses on the extent to which monetary institutions allow policymakers to commit to future policies. A key result is that if policymakers cannot commit to future policies, inflation rates are higher than if they can commit. That is, there is a time-inconsistency problem that introduces a systematic inflation bias. This study investigates the magnitude of the inflation bias in two standard general equilibrium models. One is the cash-credit good model of Lucas and Stokey (1983). The other is the limited-participation model ofmoneydescribed by Christiano, Eichenbaum, and Evans (1997). We find that in these models, for a large range of parameter values, there is no time-inconsistency problem and no inflation bias.

In the Kydland-Prescott and Barro-Gordon literature, equilibrium inflation in the absence of commitment is the outcome of an interplay between the benefits and costs of inflation. For the most part, this literature consists of reduced-form models. Our general equilibrium models incorporate the kinds of benefits and costs that seem to motivate the reduced-form specifications. (For related general equilibrium models, see Ireland 1997; Chari, Christiano, and Eichenbaum 1998; and Neiss 1999.)

To understand these benefits and costs, we must first explain why money is not neutral in our models. In both models, at the time the monetary authority sets its money growth rate, some nominal variable in the economy has already been set. In the cash-credit good model, this variable is the price of a subset of intermediate goods. Here, as in the work of Blanchard and Kiyotaki (1987), some firms must post prices in advance and are required to meet all demand at their posted price. In the limited-participation model, a portfolio choice variable is set in advance. In both models, higher than expected money growth tends--other things being the same--to raise output. The rise in output raises welfare because the presence of monopoly power in our model economies implies that output and employment are below their efficient levels. These features give incentives to the monetary authority to make money growth rates higher than expected. Thus, inflation clearly has benefits in these models.

Turning to the costs of inflation, we first discuss the cash-credit good model. We assume that cash good consumption must be financed by using money carried over from the previous period. If the money growth rate is high, the price of the cash good is high, and the quantity of cash goods consumed is low. This mechanism tends to reduce welfare as the money growth rate rises.

In the cash-credit good model, the monetary authority balances the output-increasing benefits of high money growth against the costs of the resulting fall in cash good consumption. Somewhat surprisingly, we find that there is a large subset of parameter values in which the costs of inflation dominate the benefits at all levels of inflation and money growth above the ex ante optimal rate. …

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