Time consistency and optimal monetary policy: the application of Bayes correlated equilibrium to inflationary bias
Nicholas Demestichas
Across the 1970s, many OECD countries experienced high and volatile inflation rates, primarily driven by oil price shocks, regulatory changes, and fluctuating policy responses. This economic instability was further exacerbated by central banks often responding to these economic conditions without a clear, consistent strategy. Fortunately, a breakthrough was achieved by Kydland & Prescott 1977, who associated this period of irregularity with the notion of time-inconsistency, where policies deemed optimal at one point in time could become suboptimal as economic conditions and policymakers’ incentives change. Thus, the solution was not hard to realize: the ability of policy makers to conduct discretionary policy results in a positive inflationary bias. This lack of forward-looking policy consistency led to heightened uncertainty and contributed to the volatile inflationary patterns observed during this decade. A new era emerged in the mid-1980s with the onset of the Great Moderation (GM). This period was characterized by low, stable inflation and steady economic growth, providing a case study for examining the impact of monetary policy frameworks on economic stability. During this time, a paradigmatic shift in monetary policy was observed, where central banks embraced explicit or implicit inflation targeting as part of their policy frameworks. Clarida, Gali, & Gertler 1999 demonstrated how this shift towards a more transparent and rule-based policy approach contributed to reducing the volatility of inflation.
In the aftermath of the Global Financial Crisis (GFC) and later the COVID-19 pandemic, the traditional inflationary framework known from the GM was dismantled and economies faced persistent periods of inflation (fig.1).
Aggressive quantitative easing during the GFC and fiscal expansion in response to the pandemic led to prolonged low interest rates, destabilizing the previous inflation anchoring mechanisms. These disruptions reveal that inflation is not solely a monetary phenomenon
Fig.1 – Harmonized Index of Consumer Prices (HICP) – Monthly Data (Eurostat). Comparison between Germany, Greece, EU Average, Euro Area and France
but is also influenced by global supply chain dynamics, fiscal actions and shifts in consumer behaviour. The combination of these three factors has resulted in a more unpredictable pattern of inflation, deviating from the traditional models, and requiring a re-examination of policy tools.
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