Inflation Price Level

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When we consider inflation, which describes the general increase in the aggregate price level, we usually associate this with a monetary policy as the remedial measure. In the past governments were usually the sole body that were in charge of maintaining a sustained inflation rate. However, over the past 50 years there seems to have been a movement in most western countries towards fashioning anti-inflationary policy to an independent central bank. This results in the central bank being able to use interest rates to maintain the level of inflation in the economy without any political interference. Countries such as Germany Switzerland have adopted this path and have given their central banks the full independence to control inflation and whilst the UK has adopted this methodology, they have not fully reached the level independence in their structure. We will discuss further the implications of this switchover and how it may enhance the credibility of the monetary policy, we use monetary policy as good target in our discussion because the policy attribute we care about cannot directly measure credibility but maps directly into a policy outcome we can measure, inflation which seems to give a good indication on credibility.

Firstly, it is necessary for us to consider what inflation is and why it may be a problem for governments or an economy? Inflation measures the annual rate of change of the general price level in the economy. Inflation is a sustained increase in the average price level of goods and services. We focus here on the overall level of prices throughout the economy rather than prices in one particular market or industry. The stem of the problem can have negative implications for the economy as a whole. If inflation is low, the effects may be small. But in periods of high inflation, known as hyperinflation, the negative effects will cripple an economy, a common problem associated is uncertainty this occurs when future prices are unknown, making it difficult to plan investment and consumption decisions.

The problem of inflation can be limited by the effective use of monetary policy which involves changing the base rate of interest to influence the rate of growth of aggregate demand, the money supply and ultimately price inflation. Monetarist economists advocate that monetary policy is a more powerful weapon than fiscal policy in controlling inflation. So who should take the responsibility of implementing and maintaining a low inflation?

The government is good candidate for the role as they have a general prediction of where the economy is heading and therefore is able to set targets which coincides with other economic objectives. However, handing the monetary policy to an independent central bank will give the entity the responsibility of maintaining the stability of the national currency and money supply. The idea of the changeover is to enhance the social implications and trustworthiness of the monetary policy this changeover would result in a better move for society. We will show some of the benefits of having an independent central bank in charge of the monetary policy.

The main purpose of central bank independence is primarily to protect interest rate choices from interference from the government in the belief that, due to imperfections in the electoral process, governments face incentives to choose interest rates that are lower than would be consistent with the inflation target. Governments are interested in being popular and low rates are always more popular then high rates. It is often assumed that governments have a shorter time horizon than the society they serve. Therefore, they might be tempted to hold down interest rates to stimulate spending ahead of an election, disregarding the longer-term potential consequence of inflation.

Another incentive for governments to lower inflation is that inflation helps the government's budget. When price levels rise, the demand to hold currency also rises, so inflation provides governments with extra seigneurage (the income from issuing currency). Inflation also reduces the real value of government debts. But for this to be beneficiary, inflation expectations must be low when the government borrows by selling its fixed-interest long-term bonds. On the other hand if high inflation was expected, long-term interest rates would also be higher to reflect this. Thus the ideal short-term behavior for a government that wishes to finance its debts most cheaply is to induce the belief that there will be low inflation so that it can borrow cheaply, then to cheat by allowing some inflation to write down the real value of its debts. This incentive is strong for those governments with large national debts, for whom debt interest forms a substantial part of expenditure.

A further justification for central bank independence is that it is supposed to give credibility to monetary policy. People know about the incentives that the government faces, so if the government is responsible for day-to-day interest rate decisions, there is the suspicion that it will be tempted to set them too low. If there is high inflation, people will expect high inflation to continue and they will doubt any promises by the government that it will strive for low inflation. However, if there is an independent central bank that is immune to the incentives that tempt the government, people will believe that it will genuinely try to meet its inflation target.

On the other hand, Muscatelli notes, some problems may arise when monetary policy is delegated to an independent central bank, especially when the central bank's preferences are uncertain. Two conclusions emerge from his theoretical analysis:

First, in countries where there is a low degree of agreement over the relative merits of maintaining low inflation as opposed to stabilising output and employment, the central bank may have very different preferences from those of the average voter. This means that an unelected central bank may have different aims from those of an elected government. The result is a degree of inflation control and output stabilisation that is unacceptable from society's point of view. A natural implication is that central bank independence cannot be imposed when there are sharp divisions in society over the relative merits of low inflation and stabilisation policy. This explains why independent central banks have emerged in countries where there is a stronger consensus on the costs of inflation (such as Germany and the United States).

The second key conclusion is that, when an independent central bank does turn out to be desirable from society's point of view, mechanisms have to be put in place to make the central bank accountable. Examples include setting specific inflation targets for the central bank to meet, and the use of contracts where central banks are penalised for poor performance. But uncertainty in the central bank's desired economic objectives means that it is difficult to design such targets and contracts.

There is also the argument that full central bank independence has the disadvantage of severing co-ordination between monetary and fiscal policy. The government can engage in expansionary fiscal policy without regard for the inflationary consequences because the central bank is responsible for inflation control and can take the blame.

Muscatelli argues a mechanism to reduce the distortion from the existence of uncertain central bank preferences is to grant the independent central bank goal independence: the central bank should be allowed to set and announce its own inflation targets. He shows that the central bank has an incentive to reveal its preferences through setting the inflation target. Accountability may then be achieved through full independence. Arguably, economies where the central bank has operational independence but not goal independence (such as the UK, Canada and New Zealand) may not be reaping the full benefits of central bank independence. We can illustrate this using the diagram below which shows the corresponding countries independent bank plotted against the average inflation for the period 1955 to 1988.

We can mathematically show that high levels of independence can lead to lower levels of inflation. This would therefore lead to a more credible entity controlling the monetary policy.

Firstly, we start with the government and give them the sole responsibility of implementing the monetary policy;

We represent the government loss function as follows:

  • Lg = π2t + Bg(yt -y*)2with respect π, where
  • yt = πt - πet + εt

The term εt represents a white noise error term which is normally distributed with a zero mean and a constant variance. The terms πt and πet represent the inflation rate and the expected inflation, respectively. The term y* is a time-invariant output target whilst (yt -y*) represents the output gap. The parameter Bg characterises the government preference regarding the tradeoffs between inflation and output.

Private actors know their long term contractual decisions and particularly their inflation targets will be built into these decisions, this will affect government inflation policies subsequently. They know, in particular, that the government will solve for the inflation outcome that is minimisation of equation (1);

After taking expectations, solving for expected inflation and substituting the expression for expected inflation back into (3) the problem yields the following;

  • πt = BGY* - ε

BgY* is the inflationary bias which is the amount of extra inflation generated by the inability of the government to credibly commit to its announced inflation policy.

We now do the same but designate the central bank in charge of the monetary policy. In order to do this we generate the central banks loss function which is as follows;

  • Lcb = (1 +γε) π2t + Cb(yt -y*)2

The central bank will choose πt that will minimise the social loss equation (5) subject to the output constraint equation (2) taking πe as given. Under rational expectations;

  • ()Y* - ()ut

()Y* measures the inflationary bias


()Y*< BgY* (this assumes that γ > 0 and ε > 0)

From this we can conclude that inflationary bias from an independent central bank will be smaller than the inflationary bias produced by the government. Meaning the extra inflation produced by the central bank will be smaller than the inflation produced by the government.

In conclusion the argument follows whether or not central banks should be designated the role of the monetary policy one suggestion is that the central bank may not pursue the necessary targets and therefore will not act in favour of the public. However, this arrangement does seem to have worked in achieving and maintaining low inflation in developed Western economies. Germany and Switzerland are believed to have had the most independent central banks since the last war and also the best records of inflation control. The evidence also suggests that inflation is negatively correlated with independence which has become widely accepted as the norm, which further cements our thoughts that credibility can be enhanced by delegating the central bank in charge of the monetary policy.


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