Social Institutions for Overcoming Monetary Policy Credibility Problems

Macroeconomic theorists have devoted considerable attention to designing optimal rules for government policy. The arguments for why governments should set policy in terms of rules are well known. However, until recently, there has been very little formal analysis devoted to asking how macroeconomists’ policy (regime) prescriptions can be adopted in a way which is credible. This seems quite important, since the case for imposing rules on the government is often based on the view that governments are constantly tempted to deviate from socially-optimal behavior. From the “time-consistency” literature, we know that even a government concerned solely with maximizing the welfare of the representative individual may be tempted to defect from the optimal precommitment rule, whenever there are externalities). The rule that would be optimal if the government could perfectly precommit may be quite different from the optimal implementable rule. Hence it is also important to ask what kind of institutions can be designed to help implement better rules. The purpose of this note is to exposit some recent work aimed at dealing with credibility problems in policy design. To limit the scope of the paper, we will focus on monetary policy.