Delegation

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• A second way to overcome the dynamic
inconsistency of Iow-inflation monetary
policy is to delegate policy to individuals who
do not share the public's view about the
relative importance of output and inflation.

• The idea, due to

• Rogoff (1985) is simple: inflation and hence
expected inflation is lower
• when monetary policy is controlled by
someone who is known to be especially
• averse to inflation.
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• To see how delegation can address the
dynamic-inconsistency problem.
• suppose that the output-inflation
relationship and social welfare are given
• By (10.10) and (10.11); thus

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Suppose, however, that monetary policy is determined by an
individual whose objective function is

a' may differ from a, the weight that society as a whole places on inflation.

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• Recalling steps from Dynamic Inconsistency (in
this and next slide)
• Policymaker controls money growth which
determines the behaviour of agg. Demand
• If a policymaker has a binding committtment
•  π*=π

• Otherwise subst. (10.10) into (10.11),

policymaker will minimize:

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• First order condition is

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• Thus, Solving the policymaker's maximization
problem along the lines of (10.12)
• implies that his or her choice of π, given πe is
given by (10.14) with a' in place of a. Thus,

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• value of a' greater than a. Because the policymaker
puts more weight on inflation than before.

• he or she chooses a lower value of inflation for a

given level of expected inflation (at least over the
range where πe> π*);
• in addition,
• his or her response function is flatter.
• As before, the public knows how inflation is
determined.
• Thus equilibrium again requires that expected and
actual inflation are equal.

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• when we solve for expected inflation, we find
that it is given by (10.15) with a' in place of a:

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FIGURE10.4: The effect of delegation to a conservative
policymaker on equilibrium inflation

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• Now consider social welfare. which is higher when

• is lower.

• Output is equal to y bar regardless of a'.

• But when a' is higher, π is closer to π *.

• Thus when a' is higher, social welfare is higher.

• Intuitively. when monetary policy is controlled by someone who

cares strongly
about inflation, the public realizes that the policymaker has little
desire to pursue expansionary policy; the result is that expected
inflation is low.
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Rogoff extends this analysis to the case where the
economy is affected by shocks.

under plausible assumptions, a policy maker whose

preferences between output and inflation differ from
society's does not respond optimally to shocks

Thus in choosing monetary policymakers, there is a

tradeoff:

• choosing policymakers with a stronger dislike of

inflation produces a better performance in terms of
average inflation, but a worse one in terms of
responses to disturbances.
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• As a result, there is some optimal level of
"conservatism' for central bankers."
Again, the idea that societies can address the
dynamic-inconsistency problem

by letting individuals who particularly dislike

inflation control monetary policy appears
realistic.

In many countries, monetary policy is determined

By independent central banks rather than by the
central government
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And the central government often seeks out individuals
who are known to
be particularly averse to inflation to run those banks.

The result is that

those who control monetary policy are often known for
being more concerned
about inflation than society as a whole. and only rarely
for being
less concerned.

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• Empirical Application: Central-Bank Independence and
Inflation
Theories that attribute inflation to the dynamic Inconsistency of
low inflation monetary policy are difficult to test.

the theories suggest that inflation is related to such variables as:

the costs of inflation,

policymakers‘ ability to commit,
their ability to establish reputations, and

the extent to which policy is delegated to individuals who

particularly dislike inflation.
All of these are hard to measure.

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One variable that has received considerable attention is
the independence of the central bank.

Alesina (1988) argues that central-bank independence

provides a measure or the delegation of policymaking to
conservative policymakers.

intuitively, the greater the independence of the central

bank,
the greater the government's ability
to delegate policy to individuals who especially dislike
Inflation.

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Empirically, central-bank independence is
generally
measured by qualitative indexes based on such
factors:

• as how the bank's governor and board are

appointed and dismissed,
• whether there are government representatives
on the board, and the government's ability to
veto
• or directly control the bank's decisions,
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Investigations of the relation between these
measures of independence and inflation find
that

among industrialized countries, independence

and inflation are strongly negatively related
Figure 10.5 is representative of the results

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• There are three limitations to this finding, however.

• First, it is not clear that theories of dynamic

Inconsistency and delegation predict that

• greater central-bank independence will produce lower

inflation

• the argument that

• they make this prediction implicitly assumes that the

preferences of central bankers and government
officials do not vary systematically with central bank
independence.

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But the delegation hypothesis implies that they will.
Suppose. for example. that monetary policy depends on
the central bank's and the government's preferences.

with the weight on the bank's preference increasing in its

independence.
Then when the bank is less independent.
government officials should compensate by appointing
more inflation averse individuals to the bank.

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Similarly, when the government is less able to
delegate policy to the bank, voters should elect
more inflation-averse governments

These effects will mitigate, and might even offset

the effects of

reduced central-bank independence.

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Second, the fact that there is a negative relation
between central-bank independence

and inflation does not mean that the independence is the

source of the low inflation.

As Posen (1993) observes, countries whose citizens

are particularly averse to inflation are likely to insulate
their central banks from political pressure.

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For example, it is widely believed that
Germans especially dislike inflation, perhaps
because of the hyperinflation
that Germany experienced after World War l.

the institutions governing Germany 's central

bank appear to have been created largely
because of this desire to avoid inflation.

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Thus some of Germany's low inflation is almost surely
the result of the general aversion to inflation, rather
than of

the independence of its central bank.

Third, even if independence is the source of the low

inflation

the mechanism

linking the two may not involve dynamic inconsistency.

there are other possibilities.

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 limitations of Dynamic -Inconsistency
Theories of Inflation
theories based on dynamic inconsistency provide
a simple and appealing
explanation of inflation,

Unfortunately it is not clear that their explanation

is important to actual inflation particularly for
industrialized countries

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There are two problems,

First, the importance of forward-looking expectations to aggregate

supply central to the dynamic-inconsistency explanation, is not
well established.

for example, Canada and New Zealand took strong measures in

the 1990s to make credible commitments to low
inflation monetary policies.

New Zealand. for instance, modified the central

bank's charter to make price stability the sole objective of policy
and to
provide for the dismissal of the bank's governor If inflation falls
outside a target range,

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Yet, contrary to the predictions of dynamic-
inconsistency models,

these measures do no appear to have had a

major impact on the output-inflation relationship
in these countries

Similarly, Fuhrer (1997) fails to find any evidence

that
forward-looking expectations matter to the
behavior or US inflation.
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Second, and more important, the predictions of dynamic
inconsistency theories appear to be

contradicted by the time-series variation in inflation.

At least in industrialized countries, high inflation was

mainly a phenomenon of the 1970, not a general
characteristic of monetary policy.

Yet dynamic inconsistency theories imply that high

inflation is the result of optimizing
behavior by the relevant players given the institutions.

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Thus the theories
predict that in the absence of Changes to those
institutions, high inflation will remain.

This is not what we observe.

In the United States. for example,

policymakers reduced inflation from about 10 percent at

the end of the 1970s to under 5 percent just a few
years later,
and maintained the lower inflation without any significant
changes in the institutions or rules governing policy
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