Chapter 2: The theory of credibility: confusions, limitations and dangers
James Forder* INTRODUCTION It has become a commonplace of discussion among academics, policymakers, and indeed in opinion-forming society at large, that because of political short-termism, monetary policy is affected by a time-consistency or credibility problem which leads to inﬂation. The solution to the problem is equally widely held to be the devising of some form of commitment to a policy leading to price stability. It is these doctrines which lie behind much of the conventional wisdom of current macroeconomic policy. They certainly sustain the case for central bank independence; they were clearly instrumental in advancing much of the Maastricht Treaty; and of course they go a long way to explaining the esteem in which central bankers are now frequently held, for in this vision, they are the guardians of our credibility. Widespread as this general view now is, it owes a great deal more to confusion over time consistency and credibility than to the theory’s actual characteristics. In particular, I wish to argue that, properly understood, the theory traces inﬂation neither to political opportunism nor to short-termism. Furthermore, the literature is far from conclusive in advocating solving the problem by ﬁrm commitment to price stability. The construction of the modern policy prescription, then, cannot truly be based on the theory of policy credibility at all. Rather, I shall argue, it is based on a pseudo-credibility theory which, taking common, although more or less unsubstantiated, intuitions and combining them with misstatements of the theory of credibility, arrives at its...
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