Did Time Inconsistency Contribute to the Great Inflation? Evidence From the Fomc Transcripts

Abstract

We use evidence from detailed records of FOMC deliberations to argue that the theory of the time inconsistency problem provides a reasonable explanation of the Federal Reserve's excessively expansionary policy stance during the 1970-1978 period when Arthur Burns chaired the Board of Governors. The records suggest that the Fed perceived a Phillips curve tradeoff and political pressures that made it difficult to adopt disinflationary policies at any moment in time; the tendency toward excessively expansionary policy was exacerbated by the short-run planning horizon the Committee faced in each of a sequence of meetings. We further argue that comparative static predictions of the time inconsistency model are consistent with both the rise of inflation during the Burns years and its subsequent fall. 2 Did Time Inconsistency Contribute to the Great Inflation? Evidence from the FOMC TranscriptsThe time inconsistency problem is often invoked to explain an inflationary bias alleged to plague central banks. 1 The assumptions behind the reasoning are as follows.First, the central bank is assumed to choose policy actions on a period-by-period basis in each of its meetings; it is not constrained by rules, but instead uses discretion in each period. Second, public expectations of inflation for the upcoming period are viewed as given at the time of the meeting. Third, the economy can be characterized by an expectational Phillips curve; i.e., if inflation is higher than the public expects, unemployment will temporarily fall below its natural rate. Fourth, the central bank values a marginal reduction of unemployment below its natural rate, but is also averse to higher inflation. Finally, it is assumed that expectations are rational.With predetermined inflation expectations, the central bank sees an opportunity to lower unemployment via surprise money growth in each of its meetings. If expected inflation were zero, for example, the reduction in unemployment created by a money growth surprise would be "worth" the modest increase in inflation. However, a problem arises when public expectations are rational. The public, understanding the Fed's objectives, will correctly anticipate monetary stimulus, rendering the effort to reduce unemployment ineffective. Instead, the result is inflation. At the equilibrium level of inflation, the marginal gains from unemployment reduction are balanced by the added costs of additional inflation in the current period. This is suboptimal in comparison to a 1 Seminal contributions include Kydland and Prescott (1977) and Barro and Gordon (1983 Persson and Tabellini (2000), however, argue that these criticisms miss the point, since time inconsistency analysis does not predict that the Fed would want to generate policy surprises in equilibrium. Rather, in an inflationary equilibrium, the Fed's lack of credibility would cause a more restrictive policy to produce a recession. As a consequence, the Fed would refrain from pursuing a disinflationary policy. Some empirical evidence also supports the ...

Has the Fed been a failure?

“…Yet even here the contribution of enlightened monetary policy may be less than it appears to be: according to Barro and Gordon's (1983) theory of monetary policy in the presence of a time-inconsistent temptation to improve current-period real outcomes using surprise inflation, the higher the natural rate of unemployment, the greater the inflationary bias in the conduct of monetary policy, other things equal. According to Ireland (1999) and to Chappell and McGregor (2004), both the actual course of inflation in the 1970s and afterwards and the arguments on which the FOMC based its decisions conform to the predictions of the theory of time-inconsistent monetary policy. 21 In the presence of supply shocks, moreover, the time-inconsistency framework implies that higher inflation will be accompanied by a more marked ''stabilization bias,'' and hence by greater inflation volatility.…”

“…As economist Martin Feldstein has frequently pointed out, price stability Inflation (log difference, annualized) 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 3 Because these were episodes not merely of inflation but of stagflation, they are frequently said to have depended crucially on adverse aggregate supply shocks triggered by OPEC oil price increases. This ''traditional'' explanation has, however, been cogently challenged by Barsky and Kilian (2001) (see also Ireland, 1999;Chappell and McGregor, 2004), who concludes ''that in substantial part the Great Stagflation of the 1970s could have been avoided, had the Fed not permitted major monetary expansions in the early 1970.' ' Blinder and Rudd (2008) have in turn written in defense of the ''traditional'' perspective.…”

Rational Partisan Theory, Uncertainty, and Spatial Voting: Evidence for the Bank of England's MPC

“…THERE IS a substantial literature in the United States that uses information from transcripts of the proceedings of the FOMC to study the monetary policy-making process (see e.g. Belden, 1989;Chappell and McGregor, 2004;Chappell et al, 2005;Havrilesky and Gildea, 1992;McGregor, 1996). This body of work has provided a number of insights into how committees work and the role played by individual members (especially the Chairman), and has been followed much more recently by studies of the monetary policymaking process of the Bank of England.…”

“…At the same time, two important political business cycle theories have developed that can explain observed persistent differences in voting behavior. While rational partisan theory (Alesina, 1987(Alesina, , 1988Chappell and Keech, 1986) posits that committee members are ideologically motivated but consistent with their policy preference over time, opportunistic business cycle theory (Nordhaus, 1975;Persson and Tabellini, 1990) suggests that members ideologically close to the incumbent party may attempt to use their policies to stimulate output before elections. While evidence on both these theories has in general been mixed (e.g.…”

La courbe de Phillips : temps d’arbitrage et/ou arbitrage de temps

“…Dans la même lignée, en se basant sur 25. Des problèmes d'incohérence temporelle (Kydland et Prescott, 1977;Barro et Gordon, 1983;Chappell et McGregor, 2004) ou de mauvaises appréciations de l'activité réelle (Orphanides, 2002) Phillips (1958) fit état d'une solide relation inverse entre les taux de chômage et d'inflation salariale au Royaume-Uni, donnant ainsi matière à l'une des problématiques les plus cruciales du débat macroéconomique moderne. Depuis, bon nombre de théoriciens se sont intéressés, plus ou moins directement, aux réponses que des chocs, qu'ils soient nominaux ou réels, étaient susceptibles d'engendrer sur les décisions individuelles ou collectives des agents économiques.…”