Conservative Central Banks and Alternative Ways of Governing Inflation
As mentioned earlier, Rogoff (1985a) first analysed the issue of a conservative - and not only independent - central bank as an instrument of maximising social welfare. According to him, the degree of the central bank conservativeness, in terms of the weight put on the inflation target in its loss function, should be higher than that of the government but less than infinity.
In fact, as this weight of inflation increases, its marginal benefit, in terms of decreasing rates of inflation, decreases, whereas its cost, in terms ofincreasing unemployment, increases. At some point, if the marginal benefit and cost functions are well behaved, the two are equal, and that point marks the socially optimal degree of conservatism.
This solution has various drawbacks in terms of how it should be implemented: proper incentive schemes should be devised to induce the independent banker to implement this optimal degree of conservativeness. This can be done in terms of some form of optimal contract between the government and the central banker whereby incentives are set and a check of outcomes is required.
Guzzo and Velasco (1999) question Rogoff's conclusion by arguing that if wage setters are non-atomistic and inflation averse, conservativeness can lead to lower employment and output. Inflation can be lower either for low or very high degrees of conservativeness. The welfare of a representative worker tends to be maximal if a populist (i.e. a not conservative) central bank is in charge, ensuring low inflation and an optimal level of output and employment.[41]
By contrast, Rogoff's solution was supported to various degrees by empirical evidence in Grilli, Masciandaro and Tabellini (1991), Alesina and Summers (1993), Bleaney (1996) and Eijffinger, Hoeberichts and Schaling (1998). At least two problems arise when the issues of independence and conservatism are considered.
The first refers to the distinction between the concepts; the other, to whether a conservative central bank is the only - or the best - instrument available for coping with excess inflation.With reference to the former, Hefeker and Zimmer (2011) say that the literature about monetary policy delegation has usually taken the two concepts interchangeably. An important exception is Eijffinger and Hoeberichts (1998), who introduced two different parameters for them and showed that there exists a trade-off between independence and conservatism and that a continuum of combinations of independence and conservativeness may be socially optimal, a result that holds also in a New Keynesian framework (Eijffinger and Hoeberichts 2008) but can be frustrated by uncertainty (e.g. Hughes Hallett and Weymark 2005). Crowe and Meade (2008) link introduction of independence and conservativeness of central banks to situations of market rigidities. However, rigidities cannot be considered as given. They are, instead, endogenous with respect to other institutional features (see Gros and Hefeker 2002 for a model). Posen (1998) had pointed out that a higher degree of central bank conservatism might cause nominal wage rigidities to increase, thus raising the costs of disinflation.
With reference to the second issue arising in connection with the optimal degree of conservatism, i.e. whether a conservative central bank is the only - or the best - instrument available to cope with excess inflation, one should first consider that depending on the labour market institutions, conservatism may be a second-best solution with respect to the first-best solution represented by a situation with no imperfection and rigidities.
Acocella, Di Bartolomeo and Hibbs (2008) show that conservative, tight policies have great capacity to offset the potentially negative employment costs of decentralised bargaining when nominal wages are pre-committed and unions internalise systematic responses of the monetary authority to their wage-setting behaviour.
Moreover, conservative, anti-inflationary monetary policies always dominate liberal policies in the sense that inflation is always lower and unemployment is never higher under a tight policy versus a liberal policy. Yet, if monetary policy were compelled by law, social norms or some other reason to accommodate rising wages and prices, then macroeconomic performance would be enhanced by a flexible-wage labour market in which unions had the institutional capacity to adjust wages continuously to realisations of the money supply. In this respect, a flexiblewage labour market without binding contracts is more compatible with monetary policies that systematically accommodate nominal wage expansions.Other institutions can act as substitutes for monetary policy conservativeness. In fact, Di Tella and MacCullock (2004) show the existence of a negative relationship between inflation and unemployment benefit programmes for a panel of twenty OECD countries over the period 1961-92. High unemployment provisions thus can make the monetary authority less concerned about unemployment. In addition, corporatism can, at least partly, substitute for monetary policy conservativeness.
In addition, by applying a New Keynesian sticky wage and price model, Debortoli et al. (2017: 2) have shown that a high weight on the output gap is beneficial for society ‘as it serves as an overall proxy for other welfare relevant variables’. We can say that this kind of mandate for the central bank achieves a kind of ‘reverse divine coincidence’.
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