Policy Credibility and the Design of Central Banks

The second trend influencing the nature of central banking is for countries to formally state that a central bank's sole objective should be to ensure price stability. New Zealand, for example, in its Reserve Bank Act of 1989, stated that the Bank's monetary policy should be " directed to the economic objective of achieving and maintaining stability in the general level of prices. " 3 Likewise, Article 105 of the Maastricht Treaty establishes that " the primary objective of the ESCB shall be to maintain price stability. " The Bank of Canada and some other central banks are now bound to follow formal inflation targets. In many other countries there is considerable debate about whether their monetary policy should be exclusively geared toward attaining zero inflation. 4 These two trends have an underlying unity: they can be seen as social responses to a more fundamental problem of central bank credibility called the time inconsistency of monetary policy. To aid in understanding this connection, this article discusses the nature of the time inconsistency problem and its economic implications. The theory of time inconsistency stresses that monetary authorities are often tempted to promise low inflation now and to try to surprise the public with unexpectedly higher inflation later. However, such promises will not be believed because economic agents, understanding the authorities' incentives, realize that the promises will not be honored. Instead, economically plausible outcomes have the property that monetary authorities are not able to systematically surprise the