Academic journal article Economic Inquiry

Sustainability of the Friedman Rule in an International Monetary Policy Game

Academic journal article Economic Inquiry

Sustainability of the Friedman Rule in an International Monetary Policy Game

Article excerpt

I. INTRODUCTION

One recurring theme in the analysis of policy-making is that in many situations, policymakers can benefit from the opportunity to make a binding commitment to restrict their activities. One such situation is what is known as the "time consistency problem" in monetary policy-making. A government, or its monetary authority, out of good intention, may find it beneficial to generate unexpected inflation to fix some nonmonetary distortion in the economy, for example, goods market inefficiency due to monopoly power that is characterized by higher-than-efficient product prices. This first-best monetary policy, however, is not "time consistent" in the sense that firms foresee the government's incentive to impose monetary surprises and set their nominal prices at a higher level. As a result, the government's attempts to remedy the inefficiency in the goods market using monetary policy lead only to higher inflation, with the goods market inefficiency unchanged. Therefore, it is better for the government to make a commitment not to adopt any active monetary policy to fix the nonmonetary distortion, so that the second-best outcome with low inflation can be achieved.

For such a commitment by the government to work, it has to be credible. There does exist an implicit reputation mechanism that may make a monetary authority's commitment credible. When a monetary authority repeatedly makes policies for many number of periods, a good reputation of sticking to its commitment is important for its long-run success. Even though a deviation from the announced second-best plan may benefit the monetary authority in the short run by achieving a temporary first-best result, it would destroy the authority's reputation, and as a result, the economy would end up at an equilibrium with a high inflation that is dominated by the second-best result with low inflation. If the short-run benefits from deviation are exceeded by the long-run costs from loss of reputation, a rational government would honor its commitment and the private sector sees this. As a result, the second-best outcome is sustainable. Otherwise, the commitment of not using surprise inflation is not credible, and the second-best outcome is not sustainable.

This article studies the "commitment problem" and the sustainability of the second-best outcome in an open-economy context. The main message of this article is that trade linkage between economies may be a solution to the commitment problem facing domestic monetary authorities. In essence, free trade facilitates a competitive mechanism among sovereign governments, which reduces the short-run benefits from surprise inflation and therefore makes the low-inflation policy more credible. Importantly, if sovereign governments cooperate with one another rather than compete, the benefit from international trade in terms of making governments' commitments more credible does not exist. Therefore, another lesson of the article is that cooperation among sovereign governments in the area of monetary policy-making may not be so desirable.

We build an open-economy version of Ireland's (1997) closed-economy environment. We add a second equally sized economy and allow trade between these economies. Ireland (1997) analyzed the closed economy, concentrating on issues of government commitment to households and the possibility of a reputational equilibrium in which the optimal policy under commitment can be sustained. Our Open-economy extension allows us to look at two simultaneous monetary games: one between the two governments and the other between each government and its own private sector. Thus, this work follows in the line of previous work by Canzoneri and Henderson (1991), Henderson and Zhu (1990), and Kimbrough (1993). However, the underlying economics of our model varies significantly from that used by these authors in that our model is specified in terms of tastes and technologies. This microfounded approach has two advantages. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.