Central Banking in Eastern Europe

There is a growing academic consensus that governments can achieve

lower ination at a reduced social cost by making their central banks
independent. Nowhere is this debate more relevant than in the transition
economies of Eastern Europe, where the newly established central banks
attempts to stabilise prices have come into conict with the social objectives of national governments.
This book, written by a multinational team of experts, explores the
changing face of central banking in Eastern Europe in the light of modern
macroeconomic thinking, providing important and novel insights into the
design of monetary policy institutions.
With its authoritative content, this book will interest students and academics involved with money and banking, macroeconomics and Eastern
European studies. Professionals working for nancial institutions will also
nd plenty that will appeal within these pages.
Nigel Healey is Dean of Manchester Metropolitan University Business
School, UK. Barry Harrison is Senior Lecturer in Economics at Nottingham Trent University, UK.

Routledge international studies in money and banking

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11 Central Banking in Eastern Europe

Edited by Nigel Healey and Barry Harrison
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The ECB, the pre-Euro Bundesbank and the Federal Reserve System
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Central Banking in
Eastern Europe

Edited by Nigel Healey and

Barry Harrison

First published 2004

by Routledge
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Contents

List of illustrations
Notes on contributors
Preface
Acknowledgements
PART I

1 Theoretical perspectives on central bank independence

ix
xii
xvi
xvii
1

ALI AL-NOWAIHI AND PAUL LEVINE

2 The background to reform: central banking in a command

economy

45

NIGEL M. HEALEY AND JANET ILIEVA

3 Central banking in transition economies

68

NIGEL M. HEALEY AND JANET ILIEVA

PART II

4 The changing role of central banks in market economies

91

93

JANET ILIEVA, BARRY HARRISON AND

NIGEL M. HEALEY

5 Central bank independence and macroeconomic

performance: a survey of the evidence

107

FRIEDRICH KIMER AND HELMUT WAGNER

6 Central bank independence and ination performance in

transition economies
JANET ILIEVA, ANDROS GREGORIOU AND
NICK TSITSANNIS

141

viii Contents
PART III

7 Central bank independence in the Czech Republic

165

167

P A V E L S O U K U P , A N I T A T A C I A N D R O M A N M A T O U S E K

8 Central bank independence in Poland

193

ROBERT HUTERSKI, RICHARD NICHOLLS AND

Z E N O N W I S N I E W S K I

9 Central bank independence in Romania

224

SILVIU CERAN, LILIANA DONATH AND BOGDAN DIMA

10 Central bank independence in Bulgaria

245

GARABED MINASSIAN, JANET ILIEVA AND

OLGA TENEVA

Index

271

Illustrations

Figures
1.1 The inationary bias
1.2 The inationary bias in the open economy: co-operation
and non-co-operation
1.3 Stabilization policy with perfectly correlated shocks
1.4 Stabilization policy with perfectly uncorrelated shocks
1.5 The choice of conservatism b/bm for the delegation
regimes: ve countries
1.6 The welfare outcomes relative to social optimum: ve
countries
1.7 The lower employment variance gain and loss for a single
independent CB relative to the n others
1.8 The lower employment variance gain, G, and loss for one
independent CB, L (one), and n 1 independent CBs, (all),
relative to n 1 government-dependent CBs
2.1 Firms credit account
5.1 Average ination and central bank independence
(19551988)
5.2 Variance ination and central bank independence
5.3 Average growth and central bank independence
5.4 Average growth variability and central bank independence
6.1 Ination in selected transition economies, 19932000
10.1 Foreign currency deposits (in USD) and dollarisation of the
economy (%)
10.2 Seigniorage (monthly, net issue of BGL as per cent from
broad money)
10.3 New credits
10.4 Interest rates
10.5 Composition of the BGL deposits
10.6 Renancing in Bulgaria

11
17
19
21
22
23
27

29
56
119
120
127
127
158
252
253
254
255
255
259

Illustrations

Tables
2.1
2.2
2.3
2.4
2.5
2.6
2A.1
3.1
3.2
3.3
3.4
3.5
3.6
3.7
3.8
4.1
4.2
4.3
4.4
4.5
5.1
5.2
5.3
5A.1
5A.2
5B.1
5C.1
6.1
6.2
6.3
6.4a
6.4b
6.5a
6.5b
6.6
7.1

Banking system in socialist countries

51
Waiting for housing: international comparison, 1980s
54
Waiting for cars: international comparison, 1989
54
Sources of nancing the capital inputs
55
Foreign trade of CMEA members by trade bloc in 1970
and 1983
59
Investment and consumption
61
Occupational groups in the USSR in 1970
66
An overview of the transition economies
71
Recession and recovery in transition economies
73
The inationary price of transition
75
Share of the unofcial economy in GDP
77
General government budge balances
78
Broad money growth
81
External debt and servicing (1998)
82
The transition picture in 1999
8687
Summary of major studies using GMT index of CBI
99
Political independence of the Bank of England (1694 to
1998) using the GMT index
100
Political independence of the Bank of France (18001993)
using the GMT index
101
Political independence of the Federal Reserve (1913 to
1992) using the GMT index
103
Political independence of the German Bank (1870 to
1998) using the GMT index
104
The GMT index of political independence
113
The GMT index of economic independence
114
Legal indices of central bank independence
116
Bade and Parkins index of nancial independence
132
Bade and Parkins index of nancial independence
132
Indicator of central bank independence
133
The Cukierman, Webb and Neyapti (LVAW) (1992)
indicator for central bank independence
133136
Recent amendments of central bank law in Bulgaria,
Czech Republic, Poland and Romania
150
CBI in twenty-two transition economies (2000)
154
Central bank independence in transition countries
156
Fixed effects
160
Random effects
160
Panel results
161
Panel results
161
GLS results
162
Selected economic indicators, 1991 to 2001
172

Illustrations xi
7.2
7.3
7.4
7.5
7.6
7.7
8.1
8.2
8.3a
8.3b
8.4
8.5
8A.1
8A.2
8A.3
9.1
10.1
10.2
10.3
10.4
10.5
10.6
10.7
10A.1

Bade and Parkins index of central bank independence

182
The GMT index (1991) of central bank independence
182
Alesian and Grillis (1992) index of central bank
independence
183
Variables, weights and numerical coding for legal central
bank independence
184
Banking supervision arrangements
185
Average ination and GDP growth in chosen countries
188
Money supply growth in Poland, 1989 to 2001
195
Ination, 1989 to 2002
199
Index of legal independence
201
Index of the turnover rate of the NBP Governor
202
Variables, weights and numerical coding
214
Indices of Cukierman, Webb and Neyapti comparison
215
Index of legal independence (1997)
218
Index of legal independence (1998)
219
Index of legal independence (1999)
220
Principal steps of the monetary policy construction
(19912001)
230231
Financial institutions in Bulgaria, 1965 to 1980
248
Macroeconomic indicators
251
Functions of the central bank and the currency Board in
Bulgaria
261
Bade and Parkins (1988) index of BNB independence
262
GMT index (1991) of BNB independence
263
Alesina and Grillis index (1992) of BNB independence
264
Cukierman, Webb and Neyaptis index (1992) of BNB
independence
265
Central bank independence in transition economies
268269

Contributors

Silviu Cerna is Professor in the Faculty of Economics at the University of

the West Timisoara, Romania. He teaches money and banking and
international monetary economics at undergraduate level, and monetary policy at Masters level. His main research interests are monetary
economics and scal policy. Since 1992 he has been a member of the
Board of The National Bank of Romania. He is also a member of the
Romanian Economists Association, the French Speaking International
Association and the International Institute of Public Finance.
Bogdan Dima is Lecturer in the Faculty of Economics at the University of
the West Timisoara, Romania. He teaches money and banking and
international monetary economics at undergraduate level, and monetary and scal policy in the euro zone at Masters level. His main
research interests are monetary economics and scal policy. He is a
member of the Romanian Economists Association, the French Speaking International Association and the International Institute of Public
Finance.
Liliana Eva Donath is Professor in the Faculty of Economics at the University of the West Timisoara, Romania. She teaches money and
banking and public nance at undergraduate level, and tax administration and foreign exchange management at Masters level. Her main
research interests are monetary economics and scal policy. She is a
member of the Romanian Economists Association, the French Speaking International Association and the International Institute of Public
Finance.
Andros Gregoriou is currently Lecturer in accounting and nance at
Brunel University. His research interests are in market microstructure,
nancial accounting, nancial econometrics and transition economies.
He has published in mainstream economics and nance journals such as
Applied Financial Economics, Journal of Business, Finance and
Accounting, Ekonomia and the European Journal of Finance.
Barry Harrison is Senior Lecturer at Nottingham Trent University and

Contributors xiii
holds a visiting post at the European University at St Petersburg. He
has previously held a visiting post at the National Institute for Management of the Economy in Baku (Azerbaijan) and has also taught in
France, Germany and Holland. He has published articles on nance,
macroeconomics and European integration.
Nigel Healey is Professor and Dean of the Manchester Metropolitan University Business School. His research interests are in macroeconomic
developments in Central and Eastern Europe and the Commonwealth
of Independent States, and company strategy and economic integration
in the European Union. He has served as policy adviser to the governments of Russia and Belarus.
Robert Huterski is Lecturer at the Nicholas Copernicus University in
Torun, Poland, and is also Lecturer at the High Banking School in
Torun. Between 1990 and 1995 he worked for the National Bank of
Poland in the Economic and Banking Supervision departments. His
research interests include central banking, banking supervision, public
nance and international nance.
Janet Ilieva is a research student at the Manchester Metropolitan University Business School. Her current research interests are monetary policies in Europe and economic transition of Central and Eastern
European economies.
Friedrich Kimer is Senior Lecturer in Economics at the University of
Hagen (Fern Universitt).
Paul Levine is Professor of Economics at the University of Surrey. One of
his main research areas is macroeconomic policy with a particular
emphasis on credibility and co-ordination issues. He has published
numerous articles on these topics in the Economic Journal, the European Economic Review, the Journal of Economic Dynamics and
Control, the Journal of Monetary Economics and Oxford Economic
Papers.
Roman Matousek is Senior Lecturer in Financial Economics at the Business School, London Metropolitan University. Previously, he was a
banking expert in the Czech National Bank. He has been involved in a
number of international research projects that have focused on nancial
sector reform in transition economies. He has been a Visiting Fellow at
London Business School and at the Bank of England. In addition, he
received a prestigious Pew Fellowship from Georgetown University,
USA.
Garabed Minassian is a member of the Managing Board of the Bulgarian
National Bank and, since 1997, he has been a member of the Economic
Policy Advisory Board of the President of the Republic of Bulgaria. His

xiv Contributors
main research interests are currency board arrangements, monetary
policies and ination.
Richard Nicholls is Lecturer at the Poznan University of Economics. His
main research interests include: the management of banks; central bank
independence; methods of measuring customer satisfaction; service
quality management; and post-socialist transition economies.
Ali al-Nowaihi is Lecturer in Economics at the University of Leicester. His
main interests are in industrial organisation, macroeconomics and
mathematics. His publications have appeared in major journals including the Journal of Economic Theory, the Journal of Monetary Economics and the Journal of Algebra.
Pavel Soukup is an economic analyst at the Monetary and Statistics
Department of the Czech National Bank. His main research interests
are central bank independence, ination targeting, banking regulation,
trends in the banking sector and the impact of developments in public
nance on monetary policy.
Anita Taci works as an economist in the Chief Economist Ofce at the
European Bank for Reconstruction and Development (EBRD),
London. During 1998 and 1999 she worked as a consultant for the
World Bank. Simultaneously she held a post as a Research Fellow on
banking issues at the Economic Institute of the Academy of Sciences in
the Czech Republic. In 1996 she was awarded a scholarship from New
York University Leonard N. Stern School of Business. Her main
research interests are banking and nancial markets, and public budget
management.
Olga Teneva is Head of the Department of Economic Sciences at the
Academy of the Ministry of the Interior. She has previously served as
adviser to the President and the Governor of the Bulgarian National
Bank.
Nick Tsitsannis is currently a Research Fellow at the University of Kent.
His research interests are in labour economics and he has published in
mainstream economics journals such as Applied Financial Economics.
Helmut Wagner is Professor of Economics and Director of the Institute of
Macroeconomics at the University of Hagen (Fern Universitaet),
Germany. Prior to that, he was Professor of Economics at HWP/University of Hamburg. He has held visiting positions at the University of California (1982 to 1983), MIT (1987), the Bank of Japans Institute for
Monetary and Economic Studies (1988), Princeton University (1991 to
1992), AICGS/The Johns Hopkins University (1997), Harvard University (2000), and (several times) at the IMF. He has published extensively
in the elds of macroeconomics, monetary and international economics.

Contributors xv
Zenon Wisniewski is Professor of Economics at the Nicolaus Copernicus
University in Torun, Poland. He has been a visiting scholar at the Universities of Glasgow, Leicester, Bamberg and Munich, and at the Institute for Employment Research of the Federal Employment Services
(IAB) in Nuremberg. His main research interests are labour markets
and economic policy, and he has published extensively in leading economic journals.

Preface

For almost two decades now the delegation of monetary policy to an

independent central bank has been put forward as a possible solution to
the well-known inationary bias of time-inconsistent policy. It is now
recognised that, in addition to considerations of reputation, the solution to
the time-inconsistency problem involves central banks as independent
agents facing incentives that differ from those of the representative
government (the principal). The basic idea is that a conservative central
banker will implement time-consistent policy which will therefore deliver
lower ination costs in terms of output and employment.
Until recent times, most of the literature on independent central banks
has focussed on developed countries. Far less attention has been paid to
the transition economies of Central and Eastern Europe. The collection of
research papers presented in this book seeks to remedy this omission in
the literature. Part I of the book reviews the background to central bank
independence and provides a background for Part II assesses the
experience of ve transition economies and is the core of the book. Part
III provides a wide ranging survey of independent central banks in twentythree transition economies and assesses their independence against the
independence of the ECB.
The conclusion of these papers is that substantial progress has been
made by the transition economies reviewed in establishing new laws and
regulations which provide for an independent central bank. What emerges
is that a gap still exists between the legal degree of independence and the
actual degree of independence possessed by these newly created central
banks. In particular, instead of relying on direct regulations which distance
the inuence of government from the activities of their central bank, governments sometimes use political pressure to inuence the decisions of
central bankers.
There is widespread recognition that the autonomy of central banks is
fundamental to the reform process, providing a commitment to price and
exchange rate stability. It is hoped that this book makes a contribution to
debate on this issue.

Acknowledgements

The task of producing a book invariably involves accumulating huge debts.

This is particularly true when the book is a collective endeavour. Our
major debts are undoubtedly to our fellow contributors who brought the
full extent of their knowledge and expertise to bear in this edited volume.
They have all worked tirelessly, sometimes under great time pressure to
complete their contributions. While we express our gratitude to all our
fellow contributors, it would be invidious of us not to single out Janet
Ilieva for special praise. At various times during the writing of this book,
Janet has been our author, research assistant and secretary. But for the
energy and effort she has devoted to putting this book together, it would
never have been completed. We are also grateful to the staff at Routledge
who were both patient and supportive and in particular we thank Terry
Clague and Robert Langham. We also gratefully acknowledge the help of
Gail Welsh and Ann King in guiding this book through to the production
stage of publication.
There are also debts closer to home and economists are very familiar
with the concept of opportunity cost. Time spent writing and editing is
time that could be spent doing other things. Each of the contributors to
this book gratefully acknowledges the support of those closest to them.
Families particularly tolerate the long working hours that characterise the
lifestyle of academics the world over. We hope our readers nd the results
worthwhile.
Barry Harrison
Nigel Healey

Part I

Theoretical perspectives on
central bank independence
Ali al-Nowaihi and Paul Levine

1 Introduction
The focus of this chapter is the theoretical literature on central bank (CB)
independence. We provide a survey of the seminal contributions and of
more recent research which reassesses the earlier work.1 Section 2
describes the credibility problem. An expectations augmented Phillips
curve (or Lucas supply curve) is derived from a micro-foundations model
of labour market and rms behaviour. Having clearly set out the source of
an inationary bias in the conduct of monetary policy, Section 3 describes
a second-best solution to the credibility problem rst proposed by Rogoff
(1985a). The solution is to delegate monetary policy to an independent
central bank with an appointed board chosen to be conservative, in the
sense that they assign a higher priority to low ination than that of the
representative government. This results in a trade-off between low ination and effective monetary stabilization policy, and allows for both goal
and instrument independence. The government now exercises inuence by
its choice of banker which could alternatively be interpreted as choosing a
particular degree of CB independence.
The Rogoff delegation game is of interest because it appears to
correspond to the game now being played with more and more countries
delegating monetary policy to independent and (presumably) conservative bankers. However, we highlight a number of problems with this solution. The first is that the government has to find a central banker or
choose a degree of independence which results in exactly the right
degree of inflation averseness. The second is more fundamental and is of
particular relevance to transition economies: the solution assumes that
commitment to the type of banker or degree of independence is possible
whereas commitment to a monetary rule is not. The public must be reassured that once their expectations of inflation are formed, the government will not sack or overrule the banker and appoint a less conservative
one. The third problem is that when open-economy aspects are introduced and a role for fiscal policy allowed, the resulting interactions may
result in an equilibrium that is inefficient even when compared with the

Ali al-Nowaihi and Paul Levine

original equilibrium with representative (i.e. government-dependent)

bankers.
If, as we assert, Rogoff-type delegation is the game being played, we need
to address a puzzle that has emerged in very robust form from the empirical
literature on CBI and its effect on economic performance: governmentindependent central banks provide a free lunch, in that lower ination and
lower ination variance is apparently achieved at no cost in terms of greater
output or employment variance.2 This contrasts with the prediction of
Rogoffs model that delegating monetary policy to an independent and
ination-averse central bank would result in lower average ination, but at a
cost of an increase in the variances of output and employment. Following
Alesina and Gatti (1995), we introduce political parties and political uncertainty into an open-economy model. Our synthesis of political and openeconomy effects provides a new perspective on how the empirical puzzle
can be reconciled with Rogoff-style delegation.
Section 4 turns to rst-best solutions to the elimination of the inationary bias. These consist of, rst, an equilibrium sustained in a repeated game
by a private sector trigger strategy (Barro and Gordon, 1983) and second, a
contract approach pioneered by Walsh (1995). In the contract approach the
CB is instrument-independent but not goal-independent in that the ination rule is chosen by the government and made incentive-compatible for
an independent CB by an appropriate incentive mechanism such as an
income transfer. The main problem with both solutions is identied as
relying on equilibria concepts which are not renegotiation-proof, though in
rather different senses. Trigger strategies are not renegotiation-proof in the
sense suggested by Farrell and Maskin (1989), while Walsh contracts fail
the test of renegotiation-proofness employed in agency theory. However,
the strength of the Walsh contract, which we demonstrate, is that it can
make the conduct of monetary policy open and accountable, and thus facilitate a reputational solution to the credibility problem in which zero (or
low) ination is combined with effective stabilization policy.
Sections 2, 3 and 4 assume that governments are benevolent in the
sense that they maximize either a social welfare function for society as a
whole or, in the case of the partisan political business cycle model, governments are led by different political parties each of which is representative
of a particular section of society. Section 5 assumes that governments
value power for its own sake and derive utility from being in power as well
as raising social welfare. We also introduce government competence.
These two features lead to rational political monetary cycle models in
which economic uctuations result from a governments attempt to signal
its competence to the electorate. However, we show that political monetary cycles can be avoided if the Walsh-type contracts of Section 4
between the government and the CB are available.
Given the problems associated with Rogoff delegation, our overall conclusion and lesson for the transition economies is that mechanisms for pur-

Theoretical perspectives on CBI 5

suing the rst-best solution to the credibility problem with exible ination targets chosen by the government, and made incentive-compatible for
instrument-independent (but not goal-independent) CBs, may well constitute the most promising approach to institutional structure with the monetary regime in place in New Zealand since 1989 as the model.

2 The credibility problem

The expectations augmented Phillips curve (EAPC)
Our starting point is the well-known expectations augmented Phillips
curve (EAPC). Lucas (1972) provides early micro-foundations for this
aggregate supply relationship based on the idea that producers only
observe their own goods prices and not the aggregate price level. Here we
provide a more European perspective of the phenomenon in which
labour market distortions take centre stage. Consider the determination of
nominal wage contracts by wage-setters, who can either be regarded as
monopoly unions or minimum wage legislators. They set one-period
nominal wage contracts to minimize an expected welfare loss t1(Ut)
where:
Ut v(wt pt w
)2 (1 v)(lt l )2

(2.1)

All variables in (2.1) are expressed in logarithms, wt is the nominal

wage, pt is the domestic price level and lt denotes employment. (2.1) says
that wage-setters have bliss points w
for the real wage and l for employment and choose the nominal wage to get as close to (w
, l ) in real
wageemployment space consistent with the model of employment. To
derive the latter, assume a Cobb-Douglas production function:
Yt AKtbLt1exp(ut)
where Yt, Kt and Lt denote output, capital stock (assumed exogenous
throughout) and employment respectively in levels, and ut is a zero-mean
negative productivity shock. Then, equating the real wage with the marginal product of labour we have:
wt pt f(Kt) lt ut

(2.2)

We allow for a state-contingent component of the wage contract

through an indexing arrangement that links the ex-post nominal wage to
the price level. Writing:
w
t t1(wt)

Ali al-Nowaihi and Paul Levine

then:
wt
wt wt w
t
the expected nominal wage, is found by minimizing (2.1) subject to (2.2).
Performing this optimization, with indexing, the realized nominal wage is
given by:
wt
wt [p t1(p)]

(2.3)

where:
w
a(f(Kt) l )
w
t t1(pt) ;
(1 a)
a (1 v)/(v2)

(2.4)

Combining (2.3) and (2.4), the real wage is:

w
a(f(Kt) ll )
wt pt (1 k)(pt t1(pt))
(1 a)

(2.5)

Thus if v 0, a the expected real wage will achieve the bliss

employment level, l, specied in (2.1). At the other extreme, if v 1, a 0
the expected real consumption wage equals the bliss consumption wage
target, w
.
This model of wage determination together with employment given by
(2.2) and a Cobb-Douglas production function completes the supply side
of the model for a given exogenous capital stock. Combining (2.2) and
(2.5) we have:
(1 k)
ut
lt l [pt t1(pt)] l [t t1(t)] t

(2.6)

where l is the equilibrium employment level dened as:

lu f(K) w

l
(1 )

(2.7)

In addition, we have dened (1 )/, t ut/ and expressed the

relationship in terms of ination t pt pt1. (2.6) is our EAPC giving the
familiar positive effect of surprise ination on employment in the absence
of full indexing ( 1).

Theoretical perspectives on CBI 7

The monetary policy game
Following the seminal article by Barro and Gordon (1983), the credibility
problem involving the conduct of monetary policy is usually formalized in
the literature in terms of a game between the private sector and the CB.
The private sector consists of consumers, rms and wage-setters. We
assume large numbers of these agents so the private sector is atomistic and
does not act strategically. For the purposes of the game their behaviour is
described comprehensively by the EAPC which then constitutes the economic environment or constraint facing the CB given the expectations of
ination.
It remains to describe the moves and payoff of the CB. It is convenient
to dene the former as ination rates set in each period. Of course CBs do
not in fact set ination; but we can think of them as having ination
targets which they achieve successfully3 using the usual array of actual
monetary instruments (the money supply, short-term interest rates,
reserve ratios and so on). What is important is that the actual targets are
credible in the sense described below.
The CB objective is to achieve price stability; that is, zero ination, but
it is also aware that monetary policy has real effects in the short term and
can therefore increase employment above its equilibrium level. Ideally, all
policy-makers including the CB would prefer full employment to unemployment. If n is the full-employment level (still in logarithms and assuming a xed individual supply of labour by households) then the
unemployment rate in equilibrium (the natural rate or NAIRU) is approximately n l , say. In employmentination space the bliss point of the
CB is then (n, 0). These preferences may be captured by the social welfare
function:
Wt b(lt n)2 t2

(2.8)

This asserts that the variability of employment creates welfare costs.

Whether this rationale for stabilizing the economy using monetary and
scal policy is valid is a question that remains an unresolved controversy in
macroeconomics. To explore this issue, rst suppose that the labour
market clears and there is no unemployment. Any stabilization gains are
then only those from stabilizing consumption about its mean. Lucas (1987)
argues that these are insignicant. For a logarithmic utility function in consumption, this is easily seen by expanding log Ct as a Taylor series about its
trend path log C
t and taking expectations to give the approximation
(log(Ct)) log C
t
(c/C
t)2
where c2 is the variance of consumption. Thus eliminating the variability
t)2 a generous estimate of
of consumption raises expected utility by
(c/C

Ali al-Nowaihi and Paul Levine

which is 0.5 (0.02)2 0.0002. Compare this with raising mean consumption by 1 per cent which raises expected utility by an amount 0.01. Thus
eliminating consumption variability of up to 2 per cent of mean consumption is equivalent to less than the welfare gain from a 0.02 per cent
increase in consumption.
Suppose now that unemployment is the only source of uncertainty
facing the household who have one level of consumption CE when
employed and CU when unemployed. The probability of the representative
household being unemployed is 1 u, where u is the unemployment rate.
Then expected utility is (1 u)log CE u log CU and is independent of the
variability of the unemployment rate. Again there seems to be no case for
stabilization policy as implied by our loss function (2.8).
Any potential gains from stabilization policy must be in the form of
indirect benets not captured by the model. One possible source arises
from the hysteresis effects of long-term unemployment. According to this
view the long-term unemployed lose their skills and the work habit, and in
effect withdraw from participation in the labour market. This raises the
equilibrium level of unemployment. Another possible indirect benet
from stabilization arises from the effect of output variability on investment. If the latter is irreversible then the new investment theory (see e.g.
Dixit and Pindyck, 1994) suggests that output uncertainty from supply
shocks could reduce investment signicantly (treated as exogenous in our
model). This could have substantial welfare consequences especially in an
endogenous growth context. These linkages have yet to be fully explored
even theoretically in the macroeconomic literature. Informally these arguments suggest a social welfare function of the type (2.8) with output
replacing employment.
A second ad hoc feature of these loss functions is the assertion of
convex costs of ination and an implied bliss point of zero ination. This is
another difcult area in macroeconomics. It seems unlikely that the shoeleather costs associated with a positive nominal interest rate amount to
signicant welfare costs. Costs associated with tax distortions (not present
in our model anyway) could be easily overcome by indexation. The most
plausible costs are associated with the link between high ination, its variability and investment. It would be true especially in an endogenous
growth context, but again these linkages are not well understood. In the
absence of a well-articulated theory of the costs of output or unemployment variability and of the costs of ination (other than the insignicant
shoe-leather costs), we stick to a second-best research strategy of combining a micro-foundations model with a plausible, but ad hoc, loss function
(2.8).
The remaining ingredient in the game is the model of expectations.
Before the rational expectations revolution, for instance in the work of
Milton Friedman who introduced the EAPC into macroeconomics, the
usual scheme was the adaptive expectations rule:

Theoretical perspectives on CBI 9

t1(t) t2(t1) [t1 t2(t1)]; [0, 1]

(2.9)

which says that this periods forecast equals last periods forecast plus
some proportion of the observed forecast error. With this formulation
there is no credibility problem. The credibility or time-inconsistency
problem, rst raised by Kydland and Prescott (1977), only emerges with
rational expectations. In game-theoretic terms this amounts to assuming a
complete information game, or a game in which the private sector knows
the nature of the CBs calculations and uses this knowledge to form its
expectations.
Pre-commitment and the time-inconsistency problem
To see the nature of the credibility problem assume rst that the CB precommits to an ination rule which takes the form of deterministic plus stochastic shock-contingent components t
t with
and to be
determined. The sequence of moves is:
1
2
3

The CB commits itself at the beginning of time t 0 to apply the rule

to all future periods t 1, 2, . . .
In period t 1 the private sector forms an expectation t1(t); t 1,
2, . . .
In period t the CB observes the shock t and implements the rule
t
t.

Since there are no structural dynamics in this set-up, the CBs optimization problem is to minimize the expected welfare loss 0(Wt) given the
EAPC, the sequence of events and the rational expectations assumption.
From the latter the CB can put t1(t)
. Hence from the EAPC (2.6)
and the welfare loss function (2.8) we can write:
2
2
2
2
0(Wt) 0[(
t) b(t u
t) ] bu

2
2 2
[ b(1 )

(2.10)

where 2 var(t). Minimizing (2.10) leads to the result:

b

0; 2
1 b
i.e., the optimal rule is given by:
b
t
1 b2 t

(2.11)

10

Ali al-Nowaihi and Paul Levine

The optimal pre-commitment ination rule then consists of zero average

ination plus a shock-contingent component which sees ination raised
(that is, monetary policy relaxed) in the face of a negative supply shock.
Although the pre-commitment solution is optimal ex ante at stage 1 of
the game, it ceases to be optimal ex post at stage 3 when the rule is to be
implemented. If the CB were to re-optimize at this stage, then it would
take expectations t1(t) 0 as given. Observing the shock it would then
choose the ination rate to minimize:
Wt t2 b(l t t n)2

(2.12)

leading to a revised higher ination rate:

b
t (u
t)
1 b2

(2.13)

If no mechanism exists to enforce pre-commitment then the rational

private sector will anticipate this act of reneging and the ex ante optimal
rule with zero average ination will lack credibility. The only credible rule
is then that consistent with discretion or, in other words, period-by-period
optimization by the CB.
Discretion
With discretionary policy the sequence of events is now:
1
2

In period t 1 the private sector forms an expectation t1(t); t 1,

2, . . .
In period t the CB observes the shock t and chooses the ination rate t.

To solve this game we must proceed by backwards induction and start at

stage 2. Given expectations t1(t) te say, the welfare loss (2.8) can be
written:
2
Wt t2 b[(t te) tu
]

(2.14)

Then minimizing with respect to t, the rst order condition is:

t b
\1
b
2[u
t1(t) t)

(2.15)

Proceeding to stage 1 the private sector uses (2.14) to form the expectation:
t1(t) bu

(2.16)

Theoretical perspectives on CBI 11

Hence the discretionary policy takes the form:
b
t bu
2 t
1 b

(2.17)

which has the same state-continent component as the ex ante optimal rule,
but now includes a non-zero average ination or inationary bias equal to
bu
where u
is the NAIRU.
The credibility problem may be stated simply as how to eliminate the
recalcitrant inationary bias. The latter is illustrated in Figure 1.1. The ex
ante optimal policy consistent with rational expectations (t te on the
LRPC) is zero ination at point P, but this requires pre-commitment to
enforce. In the absence of such pre-commitment at time t expectations te
formed in the previous period are given and the policy-maker may choose
a point on the SRPC to reach a utility curve closer to the bliss point B, at
point C. This is a cheating policy in which zero ination is promised and
believed, but non-zero ination is delivered. However, in a rational expectations equilibrium the private sector can anticipate the calculations of the
policy-maker. High ination is anticipated and we end up on the LRPC

Figure 1.1 The inationary bias.