It is increasingly recognised that when the announced inflation target is fully incorporated in the public's expectations regarding future inflation, an incentive for generating surprise inflation and, therefore, a little more output expansion opens up once inflation expectations are stabilised. Discretionary conduct of monetary policy allows the monetary authority to alter its instrument setting in favour of inflating the economy at a higher rate than announced (or what is socially desirable). Thus, announced policy objectives are not regarded as time consistent by the public which starts building in policy surprises into its expectation formation and this, in turn, renders monetary policy action sterile. Therefore, rather than discretion in monetary policy, simple and understandable policy rules have been favoured in the theoretical literature.

Following the seminal work on the theme (Kydland and Prescott, 1977), there has been a considerable attention in the literature on the issue of time-inconsistency of monetary policy and proximate solutions to the problem (Barro and Gordon, 1983; Rogoff, 1985; Persson and Tabellini, 1993; Nowaihi and Levine, 1994; Walsh, 1995). The resolution of the time inconsistency problem essentially involves raising the marginal cost of inflation as perceived by the central bank.

The solutions highlight the reputational constraints on central banks. Succumbing to the temptation to inflate today worsens the central bank's credibility in delivering low inflation in the future. Pursuing current expansionary monetary policy will be punished by higher inflation expectations in the future -"by punishing the central bank, the loss of reputation raises the marginal cost of inflation" (Walsh, op.cit.). The important issue is that the central bank must believe that it will be punished if it 'cheats', i.e., the credibility of trigger strategies becomes important (Friedman, 1977). If by punishing the central bank, the private sector also punishes itself, the threat to punish may not be credible. Furthermore, if the central bank has private information about the working of the economy or if the public is unsure about the central bank's true preferences, reputational constraints in the sense of chisel-proof credibility (Nowaihi and Levine, op cit) are difficult to enforce.

An alternative approach to solving the time inconsistency problem has been to focus on the preferences of the central bank. Delegating the conduct of monetary policy to a 'conservative central banker' (Rogoff, 1985), i.e., one with a low time preference and a higher preference for price stability relative to output considerations has formed the basis of a wider search for independence of the central bank as the solution to time inconsistency. If the central bank is independent and more conservative than society as a whole, caring less about output relative to inflation, then the public could treat its preferences as different from the elected governments. In a multi-sector economy, however, the process of appointing the conservative central banker can be subject to partisan influences (Waller, 1992). Moreover, if supply shocks to the economy are large, the government can override the central bank. The knowledge of overrides or escape clauses can affect the central bank's response (Lohmann, 1992). The unification of East and West Germany showed that even central banks do not operate in a political vacuum. Thus, the appointment of a conservative central banker -if one can be found at all - can reduce the inflation bias but only at the cost of distorting stabilisation policy. The experience of countries with independent central banks invested with inflation objectives suggests that central bank independence is negatively correlated with inflation (Cukierman, 1992), but central bank independence does not appear to be correlated with output variance (Alesina and Summers, 1993). Therefore, it is possible that central banks with higher weights on inflation may achieve lower inflation, but they could also experience greater output variance (Table 5.5)).

Another solution to the time inconsistency problem focuses on the incentives faced by the central bank. These incentives are shaped by the institutional structure in which monetary policy operates. In the tradition of Walsh (1995), these institutional arrangements can be represented by a contract between the central banker (the agent) and the Government (the principal). The central banker's tenure in office is conditional upon his performance of achieving low inflation, failure of which would lead to the repudiation of the contract of tenure. Drawing up a contract loaded with incentives for conservative behaviour can achieve the dual objective of eliminating the inflationary bias while ensuring the optimal stabilisation response from the monetary authority. If inflation itself is time varying, the contract can no longer be optimal although it can support optimal commitment by the central bank. Obviously, transparency and accountability have a critical role to play. New Zealand is characterised as having adopted the optimal contract approach. Such a solution is also preferred from the point of view of public choice theory: unless there are constitutional or institutional constraints to the contrary, a democracy contains a bias towards deficit finance; politicians do not necessarily pursue public interest but are more concerned with their personal or political agenda; central bank independence provides a solution which will ensure not only low inflation but also act as an effective institutional constraint8. On the other hand, it is argued that an independent central bank lacks democratic legitimacy - money is too important an issue to be left to the whims of central bankers. Secondly, independence may lead to frictions between the fiscal and the monetary authorities and the resulting costs of these frictions between monetary and fiscal policy may be somewhat costly for society, thus inhibiting the development process. Thirdly, there may be significant divergence in the preference pattern of independent central banks and the society at large. A strong central bank may impose its outlook on society resulting in a sub-optimal state in terms of economic welfare. Recent literature has stressed the difference between goal independence and instrument independence.

While the contracting approach allows complete flexibility in the operational conduct of monetary policy, an alternative approach focuses on restricting policy flexibility. A wide variety of rules have been proposed and analysed. Inflation targeting is currently the most discussed form of target rules. Strict targeting rules may not be desirable as they eliminate any stabilisation role for monetary policy and the real economy has to adjust to shocks. Flexible target rules bring back the trade-off between credibility and discretion.

A large body of literature has focused on the institutional design of co-ordination between monetary and fiscal policies as another set of solutions to the time inconsistency problem. The institutional setting and operational arrangements for the co-ordination of monetary and fiscal policies differ widely among countries. A host of factors play a role in shaping the framework of co-ordination like the country's history, socio-political considerations, nature of financial market development and the broad objectives set for macroeconomic policies. Country experiences show how fundamentally these factors have shaped the co-ordination arrangements as well as legal and administrative infrastructure to produce a wide diversity of second best solutions. Within the overarching responsibility for macroeconomic stability, the monetary and fiscal policies differ in terms of their transmission channels, the lags with which they operate, their instruments, the authorities which wield them and the specific targets assigned to them. The form and content of policy co-ordination has undergone significant changes over the years. Countries have been intensively working towards establishing multilateral and consensus rules for monetary fiscal co-ordination. The Maastricht treaty of the European Union is the first major initiative in this direction, under which automatic access to central bank credit by the government is formally prohibited and indirect credit is discretionary. The IMF's Code of Good Practices on the Monetary and Financial Transparency and Codes on Fiscal Transparency are recent important efforts in this area. The codes propose guidelines for clarity of roles, responsibilities and objectives of monetary and fiscal policies, open processes of policy formulation, accountability and integration and public availability of information.

The recent Japanese experience has underscored the lower bound of monetary policy effectiveness and has brought the potential threat of deflation into focus. The monetary policy efforts to revitalise the economy have taken real interest rates in various countries to levels below their real growth rates, producing what has been termed as the deflationary gap. A situation of persistent deflation can set off a spiral of decline in activity, deflationary expectations, zero interest rates and an ineffectiveness of monetary policy - what has been termed as the 'liquidity trap'. In such a scenario, deflation prompts consumers to postpone their current spending in expectations of fall in prices in future leading to decline in demand and further fall in prices thus generating the deflation cycle. Low or zero inflation imparts inflexibility to wages, as workers' unwillingness to accept a cut in nominal wages increases the real wage burden to the entrepreneurs, prompting them to prune the size of their work force and deepening the recession. It also makes interest rates and other financial prices rigid making the relative price signals ineffective as interest rates cannot fall below zero (negative) and hence real interest rates remain high. Moreover, deflation increases the real debt burden causing bankruptcies and bank failures.

Monetary policy authorities and the academia tend to agree that a liquidity trap is likely to bring considerable instability and real output losses. It is in this context that they advocate strategies to avoid and escape liquidity traps. It is crucial to prevent inflation and inflation expectations from falling to deflationary levels. Advance contingency plans, emergency liquidity facilities, coordinated monetary and fiscal intervention, credible and transparent inflation targets are suggested in the literature as part of the strategy to fight the deflation.

Next Module - "The Transmission Mechanism of Monetary Policy in Emerging Market Economies" (BIS Policy Paper)