To what extent is there a disconnect between theoretical models of monetary policy, and how monetary policy is conducted in the real world? Your answer should draw on the theoretical models of monetary policy we have covered in lectures, and your knowledge of the monetary policy framework at the Bank of England (minimum 950 words, maximum 1000 words).
The theories surrounding monetary policy have been radically transformed in recent decades, ultimately shaping the institutional structure and policies of central banks. The focus until recently was upon ‘a mandate, independence and accountability’ (Svensson, 2009) which closely reflected theoretical models, however the shifting nature of the economy with the current financial crisis has meant a greater disconnect between theory and practice.
The Barro-Gordon model depicted the choices policy makers face when creating monetary policy. The incentive for policy-makers to create surprise inflation is shown below:
(Taken from “The Barro Gordon model of rules vs. discretion”, Costain)
This temptation of a temporary rise in employment is correlated with the pressure on governments to achieve high results before elections. The problem becomes time-inconsistent with rational expectations and a multi-period model. The optimal policy for government is positive inflation, which agents know and thus set expectations equal to. This demonstrates the optimal result of a binding rule.
The rule vs. discretion debate highlighted the need to constrain government interference, resulting in increasing central bank independence and a focus upon long term horizons. However, rules cannot accommodate all possible events, and have created problems evident in the Thatcher government. The US policy between 1950-66, and 1985-2000 provides evidence that discretionary policy can produce good results. The assumptions of the distinction between only two types of central bankers and perfect control over the price level are deemed unrealistic.
The granting of Central Bank independence within the UK in 1997 could be seen as a response to the impetus within theoretical literature such as Barro-Gordon to do so. Following this, the MPC was said to gain instant credibility with long-tern inflation expectations falling sharply. Empirical findings below support independent central banks’ ability to sustain lower inflation with no output cost. Central banks tend to follow Fischer’s theory of instrument independence and goal dependence. The idea of “constrained discretion” is seen in the UK with the Chancellor’s requirement of a remit letter if inflation strays by 1pp from target. The independence of the UK’s Quantitative easing policy is seen by its status of “the business of the bank” (Mervyn King). However the democratic need for accountability is seen in the UK’s allowance of a member of the treasury to sit in on meetings.
Reputation and delegation are two theoretical commitment solutions to the dynamic-inconsistency problem. (Romer, 2001). Reputation plays a role in monetary policy, in a state of uncertainty such as the UK, where the image of central bankers of inflation fighting is important to establish credibility thus incentivising them to achieve targets. This issue is seen as being “near..to the hearts of real central bankers” (Blinder) and is achieved by processes such as publishing votes.
Commitment solutions rely on the importance of expectations and are prominent in theory and practice of real world policy. This is reflected in the prominent role of the Bank of England’s inflation and output forecasts. However the New Keynesian Phillips Curve assumption that a rise in inflation expectations would give rise to inflation did not hold in recent times, as shown below.
Rogoffs’ proposal of delegating monetary policy to ‘Conservative central bankers’ that are more inflation-averse than the general public provided the “intellectual framework for the redesign of the central banks” (Clement, 2008). It has been influential in the Bank of England’s appointment choices with the Conservative views of insiders dominating monetary policy (Spencer, 2009). The need for the ‘optimal level of conservatism’ explains ‘flexible inflation targets’ in many central banks, and the inclusion of ‘outsiders’ within the MPC. The use of a one-shot game and its exclusion of a disinflation possibility (Hallett, Libich & Stehlik) disconnects it from reality.
Although there is no such inclusion of a ‘performance contract’ (Walsh, 1995) within monetary policy, the theory drew attention to optimal incentive structures for central banks, which is a current focus in the financial crisis literature. The use of an inflation target which allows for output stabilisation, seen in the Svensson model (1997), is correlates with this theory and is evident in most central banks. Svensson proposes an optimal reaction function similar to the Taylor Rule, which the UK’s MPC is said to follow (Spencer 2009). However due its ‘individualistic’ (Blinder) nature consolidated in the ‘one member one vote’ system, one rule could never account for the heterogeneous views within the MPC.
However Harris & Spencer model (2009) state that “the institutional status of Bank of England MPC members” holds more importance than differing reaction functions, The MPC contains five insiders appointed from within the bank, and four outsiders, appointed from other professions and academia. Theory correlates with practice, with insiders more likely to hold conservative views and vote as a block, when compared to outsiders.
The rapid change of the economy in the recent financial crisis has led to a disconnection between theory and practice. The ‘one tool, one target’ approach has proved inadequate in dealing with the financial crisis. Blanchflower (2009) stipulated the exclusion of the financial sector as the reason the Central Bank was slow to realise the severity of the crisis. The effect of the financial crisis confirms the view that theory arises from events, and their unpredictability means models will always contain shortfalls. Shortfalls are also evident in healthy economies. The complete markets assumption seen in such influential models like the DSGE and the ones discussed above does not hold in a world “characterised by herding behaviour & speculative bubbles” (Blanchflower, 2009). Critics cite the inclusion of fiscal policy within models as likely to alter results.
In conclusion, the models I have discussed have been influential in determining the institutional structure of the bank, the type of central banker appointed and how they are done so. They have signified the importance of the role of bank incentives and expectations in forming policy. However as the recent financial crisis has shown, in such a dynamic complicated world littered with uncertainties, generalised models can never satisfy all the demands of practical monetary policy.