8. Central Bank Independence

Why might U*<U^N be more socially optimal?

• This might arise if the labour market is suject to imperfections, like market distortions (because of taxes)

• There might also be monopolistic competition meaning that equilibrium output is too low; more employment is required to increase the rate of output towards the natural level

How to solve U*<U^N being socially optimum?

• Unemployment less than the natural rate is suboptimal, even if it is socially optimal

• The first solution is to get rid of the labour market distortions

  • These might be solved with supply-side policies

• The second is to aim for a higher output target than the equilibrium outcome

How is U*<U^N politically motivated?

• Politicians might be motivated to aim for this unemployment level due to political economic cycles; it might be attractive to have low unemployment just before an election

• The policymaker is tempted for their own success

  • Milton Friedman writes a paper on this, arguing that government’s might involve in “irresponsible government tinkering” (1962)

Why don’t central banks have adverse political motives?

• He argues that there is no time-inconsistency in central banks because they do not have political motivations which are similar to microeconomic structural reforms 

• There is no reason for them to create job expansion which can’t exist in the long-run 

• They do have a dual mandate to care about stable prices and employment, but it is more about stabilisation

• Thus, independent policymakers can consistently aim for U*=U^N

Trump attempting to influence the FED

• Trump attempted to fire the Federal Reserve Governor for Lisa Cook

  • The courts have refused this, in a landmark victory for Central Bank Independence

• Trump has an insider called Stephen Miran, who opposed a half-point cut claiming that tariffs have no material effect on inflation and the White House’s immigration crackdown will lessen price pressures

• Trump has threatened Jerome Powell verbally, claiming rates should be lower

How does the FED respond to Trump interference?

• Lohmann’s model, which combines a Barro-Gordon type model with game theory attempts to analyse the outcome (1992)

• Government could delegate monetary policy but decrease the CB independence, but this incurs a cost 

  • The government reserves the right to override the CB, meaning there is a cost from less inflation stability

• The model is extended to incorporate shocks

Optimal policy response

• Is always state-contingent — completely dependent on the state of the world, meaning that the policymaker shouldn’t always aim for the target level inflation but must choose around it to maintain stability 

• The only instrument in this middle is monetary policy (the inflation rate) but trying to meet a dual mandate with it - difficult

• The FED knows a decision which is too different from the Government will lead to the Government overriding it, so instead of doing this, the FED will choose the policy which is closest to their preferred choice without causing the Government to get involved 

  • Thus, the FED will probably concede to some of Trump’s demands, lowering inflation below their preferred rate, but less than Trump wants so that he doesn’t fire them all and override them

    • The FED cares about itself!

Lohmann Model Summary

• U_t = U^N - b(p_t-p_t^e) - z_t is our lecturers inverted Phillips curve model, whereas Lohmann uses    y = pi - w + z, which is a supply function; these two curves correspond by an ‘Okun’s Law’ relationship, where y_t = - 1/b (U_t)

• The loss function becomes L_t = (U_t - U*)² + a(p_t - p*)² + dc, where dc is the explicit cost of a government takeover; d is a dummy variable, which is zero if no takeover and 1 if there is 

• ‘p’ represents pi in this model 

• Monetary policy consists of choice pi_t

Lohmann Model Timeline

• Government chooses the cost of a takeover, c

• Public sets inflation expectations, pi_t^e

• Shock is realised, z_t

• CB sets inflation target given expectations and the shock, pi_t

• Government decides where to intervene

• Given these, output is determined giving the loss, U_t, L_t

Realised inflation under the Lohmann Model

Outcomes of delegation to a conservative central bank

Policymaker reaction functions