Imperfect Credibility versus No Credibility of Optimal Monetary Policy

TL;DR

This paper explores how even minimal credibility from a central bank can stabilize inflation expectations, while complete lack of credibility leads to instability, highlighting the importance of quasi-commitment in monetary policy.

Contribution

It demonstrates that quasi-commitment is essential for anchoring inflation expectations and stabilizing inflation, contrasting it with the destabilizing effects of optimal discretion.

Findings

Quasi-commitment stabilizes inflation dynamics.

Lack of credibility causes local instability.

Policy response signs differ under quasi-commitment and discretion.

Abstract

A minimal central bank credibility, with a non-zero probability of not renegning his commitment ("quasi-commitment"), is a necessary condition for anchoring inflation expectations and stabilizing inflation dynamics. By contrast, a complete lack of credibility, with the certainty that the policy maker will renege his commitment ("optimal discretion"), leads to the local instability of inflation dynamics. In the textbook example of the new-Keynesian Phillips curve, the response of the policy instrument to inflation gaps for optimal policy under quasi-commitment has an opposite sign than in optimal discretion, which explains this bifurcation.