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APPENDIX

Time Inconsistency and the Tradeoff Between Inflation and Unemployment

In this appendix, we examine more formally the time-inconsistency argument for rules rather than discretion. This analysis is relegated to an appendix because we need to use some calculus.8

Suppose that the Phillips curve describes the relationship between inflation and unemployment. Letting u denote the unemployment rate, un the natural rate of unemployment, π the rate of inflation, and Eπ the expected rate of inflation, unemployment is determined by

u = un – α(π – E π).

Unemployment is low when inflation exceeds expected inflation and high when inflation falls below expected inflation.

For simplicity, suppose also that the Bank of Canada chooses the rate of inflation. Of course, more realistically, the Bank of Canada controls inflation only imperfectly through its control of the money supply. But for the purposes of illustration, it is useful to assume that the Bank of Canada can control inflation perfectly.

The Bank of Canada likes low unemployment and low inflation. Suppose that the cost of unemployment and inflation, as perceived by the Bank of Canada, can be represented as

L(u, π) = u + γπ2,

where the parameter γ represents how much the Bank of Canada dislikes inflation relative to unemployment. L(u, π) is called the loss function. The Bank of Canada’s objective is to make the loss as small as possible.

Having specified how the economy works and the Bank of Canada’s objective, let’s compare monetary policy made under a fixed rule and under discretion.

First, consider policy under a fixed rule. A rule commits the Bank of Canada to a particular level of inflation. As long as private agents understand that the Bank of Canada is committed to this rule, the expected level of inflation will be the level the Bank of Canada is committed to produce. Since expected inflation equals actual inflation (Eπ = π), unemployment will be at its natural rate (u = un).

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What is the optimal rule? Since unemployment is at its natural rate regardless of the level of inflation legislated by the rule, there is no benefit to having any inflation at all. Therefore, the optimal fixed rule requires that the Bank of Canada produce zero inflation.

Second, consider discretionary monetary policy. Under discretion, the economy works as follows:

1. Private agents form their expectations of inflation E π.

2. The Bank of Canada chooses the actual level of inflation π.

3. Based on expected and actual inflation, unemployment is determined.

Under this arrangement, the Bank of Canada minimizes its loss L(u, π) subject to the constraint that the Phillips curve imposes. When making its decision about the rate of inflation, the Bank of Canada takes expected inflation as already determined.

To find what outcome we would obtain under discretionary policy, we must examine what level of inflation the Bank of Canada would choose. By substituting the Phillips curve into the Bank of Canada’s loss function, we obtain

L(u, π) = un – α(π – Eπ) + γπ2.

Notice that the Bank of Canada’s loss is negatively related to unexpected inflation (the second term in the equation) and positively related to actual inflation (the third term). To find the level of inflation that minimizes this loss, differentiate with respect to p to obtain

dL/dπ = –α + 2γπ.

The loss is minimized when this derivative equals zero. 9 Solving for p, we get

π = α /(2γ).

Whatever level of inflation private agents expected, this is the “optimal” level of inflation for the Bank of Canada to choose. Of course, rational private agents understand the objective of the Bank of Canada and the constraint that the Phillips curve imposes. They therefore expect that the Bank of Canada will choose this level of inflation. Expected inflation equals actual inflation [Eπ = π = α /(2γ)], and unemployment equals its natural rate (u = un).

Now compare the outcome under optimal discretion to the outcome under the optimal rule. In both cases, unemployment is at its natural rate. Yet discretionary policy produces more inflation than does policy under the rule. Thus, optimal discretion is worse than the optimal rule. This is true even though the Bank of Canada under discretion was attempting to minimize its loss, L(u, π).

At first it may seem bizarre that the Bank of Canada can achieve a better outcome by being committed to a fixed rule. Why can’t the Bank of Canada with discretion mimic the Bank of Canada committed to a zero-inflation rule? The answer is that the Bank of Canada is playing a game against private decision-makers who have rational expectations. Unless it is committed to a fixed rule of zero inflation, the Bank of Canada cannot get private agents to expect zero inflation.

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Suppose, for example, that the Bank of Canada simply announces that it will follow a zero-inflation policy. Such an announcement by itself cannot be credible. After private agents have formed their expectations of inflation, the Bank of Canada has the incentive to renege on its announcement in order to decrease unemployment. (As we have just seen, once expectations are given, the Bank of Canada’s optimal policy is to set inflation at π = α/(2γ), regardless of Eπ.) Private agents understand the incentive to renege and therefore do not believe the announcement in the first place.

This theory of monetary policy has an important corollary. Under one circumstance, the Bank of Canada with discretion achieves the same outcome as the Bank of Canada committed to a fixed rule of zero inflation. If the Bank of Canada dislikes inflation much more than it dislikes unemployment (so that γ is very large), inflation under discretion is near zero, since the Bank of Canada has little incentive to inflate. This finding provides some guidance to those who have the job of appointing central bankers. An alternative to imposing a fixed rule is to appoint an individual with a fervent distaste for inflation. Perhaps this is why even liberal politicians who are more concerned about unemployment than inflation sometimes appoint conservative central bankers who are more concerned about inflation.