What incentives arise for a central bank to fall into the time-inconsistency trap of pursuing ov

step 1 Oeally expansionary monetary policy pursued by a central bank comes with, of course, incentives

What incentives arise for a central bank to fall into the...

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Key Concepts

Time Inconsistency

Time inconsistency refers to the phenomenon where the optimal plan devised in advance is no longer optimal when the future arrives. In the context of monetary policy, a central bank may establish a policy that appears beneficial in the long term, but when the moment of action comes, the temptation to deviate from that plan for short-term gains can lead to suboptimal outcomes, such as higher inflation.

Inflation Bias

Inflation bias is a systematic tendency for discretionary monetary policy to generate higher inflation than would be warranted by economic fundamentals. This arises because policymakers, incentivized by short-term objectives like boosting employment or output, may adopt overly expansionary measures that eventually result in higher inflation without sustainably improving economic performance.

Credibility and Commitment

Credibility and commitment are crucial for ensuring that the public and markets trust the central bank's policy actions. When a central bank is tempted to pursue excessively expansionary policies, its inability to commit to a conservative stance can undermine its credibility. This loss of trust makes it harder to anchor inflation expectations, reinforcing the dilemma of time inconsistency and making an inflation bias more likely.

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