Overhead 3b Credibility in Economic Policy

Credibility in Economic Policy

  • Focuses on the debate between rules and discretion in economic policy-making.

Introduction

  • Lucas Critique: States that policy changes affect agents' behavior.

    • Agents consider policymakers' potential future behaviors when forming expectations.

    • The interaction is modeled as a game between policymakers and agents, facilitating the understanding of reactions to behavioral changes.

Example: Capital Taxation

  • Reference: Kydland and Prescott (1977) Study.

    • Scenario: Government announces a 20% reduction in capital taxation starting next year.

    • Expectation: Agents invest more capital upon believing the announcement.

    • Incentive Shift: After installation, the government may have the incentive to revoke the announcement and increase taxes instead.

    • Rational Expectations: Agents are aware of the economic context and government's probable behaviors, leading to disbelief in the announcement, rendering the policy ineffective.

Example: Monetary Policy

  • Lucas’ Aggregate Supply Equation: [y = \bar{y} + \alpha \pi - \pi^e + \epsilon]

  • Social Loss Function: [\Omega = \frac{1}{2} (y - y^*)^2 + \frac{\beta}{2} \pi^2]

    • Policymaker aims to minimize deviations from target output ((y^* > \bar{y})) and control inflation.

Game Theoretic Approach

  • Four Stages:

    1. Policymaker decides whether to announce a policy.

    2. Agents react based on the announcement (if any).

    3. Aggregate supply shock becomes known.

    4. Policymaker chooses to implement the announced policy or not.

  • Three Options for Policymakers:

    1. Discretionary: No announcement made.

    2. Policy Rule: Announce a policy and adhere to it.

    3. Cheating: Announce a policy but deviate from it post-announcement.

Discretionary Policy

  • Policymaker does not make an announcement regarding policies.

    • Sub-Optimality: This approach leads to a higher loss function value when compared to other policy options.

Policy Rule

  • Policymaker declares an inflation target of (\pi = 0) and sticks to it.

    • Agents initially believe in this announcement.

    • Time Inconsistency: The policymaker may have an incentive to invalidate the announcement later.

Cheating Policy

  • Policymaker announces an inflation target of (\pi = 0) but decides to cheat by opting for higher output levels.

    • Expectation vs Reality: If agents believed the announcement, it could minimize the loss function.

    • Credibility Issue: Agents are aware of the model, implying that the policymaker's announcement lacks credibility because agents anticipate potential deviations.

Solutions to the Time Inconsistency Problem

  • Building Reputation: Policymaker aims to establish a trustworthy reputation over time.

  • Independent Central Banks: Assign separate output and inflation targets to the government and central bank, respectively, to reduce conflicts of interest.

  • Longer Terms for Central Bankers: Ensures independence from short-term governmental pressures.

Examples of Monetary Policy Rules

  • Constant Money Growth Rate: Maintains a stable increase in the money supply.

  • Target Growth Rate of Nominal GDP: Focuses on nominal GDP growth as a target.

  • Target Inflation Rate: Sets a specific inflation target.

  • Taylor Rule: [i = \pi + 2 + 0.5(\pi - 2) + 0.5(GDP Gap)]

    • Adjusts interest rates based on inflation and economic output.