Central Bank Credibility and Canadas Experience with Inflation Targeting

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Central Bank Credibility and Canadas Experience
with Inflation Targeting

• Dr. Farid Novin

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Introduction

• Over the last 15-20 years, the concept of
  credibility has become a central concern of the
  scholarly literature on monetary policy.
• Under certain assumptions, including rational
  expectations, a completely credible central bank
  can engineer a disinflation without suffering any
  adverse effects on employment.
• But central bank credibility is relevant even if
  expectations are less than fully rational.
• As long as expectations matter a central banks
  credibility should influence how its monetary
  policy actions affect forward-looking variables
  like longterm interest rates and other asset
  prices.

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General Equilibrium Conditions With Inflation
Rate Targeting
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Equilibrium Conditions in the Goods and Money
Markets
The Bank of Canadas Exchange Rate Model
ior
AD
GAP
e
y
e
SAS
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Equilibrium Condition in the Labour Market
y
ybar
y1
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Definition

• Blinder defines credibility as matching deeds to
  words A central bank is credible if people
  believe it will do what it says.
• In the academic literature, central bank
  credibility is often identified with one of three
  things
• 1. strong aversion to inflation,
• 2. incentive compatibility,
• 3. precommitment.

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WHY IS CREDIBILITY IMPORTANT?

• 1. Greater credibility makes disinflation less
  costly,
• 2. helps hold down inflation once it is low
• 3. makes it easier to defend the currency
• 4. helps garner public support for central bank
  independence.

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• The expectational Phillips curve shows the
  importance of inflation expectations
• pt pte - ß (yt - ) ?zt et .
• Here pt is the inflation rate, pte is its
  expectation, yt - is the gap between the
  actual and NAIRU output, zt is a supply shock
  variable (or vector), and et is the disturbance
  term.

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• Perfectly credible announcements of disinflation
  will reduce pte abruptly, enabling pt to fall
  without the necessity of a period of slow
  economic growth.
• Will work even if price (or wage) stickiness
  included in the model.
• Greater credibility improves the short-run
  inflation-economic growth tradeoff.

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• Similarly, another hypothesis states that once
  low inflation has been achieved, a more credible
  central bank is better able to maintain low
  inflation.
• Looking back at the Phillips curve
• pt pte - ß (yt - ) ?zt et,
• inflation shocks (z or e) are less likely to get
  embedded in inflationary expectations.

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The Bank of Canada and Credibility

• The Bank of Canada subscribes to the view that
  the pursuit of price stability will lead to the
  best prospects over time for the level and growth
  of real output in the economy.
• In Canada we operate with inflation-control
  targets which aim to keep inflation within a one
  to three per cent band.
• Flexible exchange rate

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• The Bank of Canada has a monopoly over the
  creation of settlement balances
• used to settle transactions among the directly
  clearing financial institutions in the payments
  system.
• The Bank thus can strongly influence the one-day
  (overnight or call) interest rate by changing
  the availability of settlement balances and thus
  the rate at which direct clearers will transact
  in an attempt to obtain balances for one day.

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• Typically, when the Bank of Canada reduces its
  overnight rate, rates will tend to move downwards
  all along the term structure.

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AD1
AD2
SAS
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Affect of a Change in Interest Rates

• Slowing economy
• Reduce interest rates
• Spending encouraged / saving inhibited
• Deteriorated terms of trade
• Smaller gap between aggregate supply and
  aggregate demand
• or
• Overheating economy
• Raise interest rates
• Spending discouraged / saving encouraged
• Improved terms of trade
• Smaller gap between aggregate supply and
  aggregate demand

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• The gap between aggregate demand and aggregate
  supply, along with inflation expectations, is
  very important in affecting the rate of
  inflation.
• Empirical work tends to indicate that excess
  demand has a greater effect on inflation that
  excess supply.

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Implications for the policy process

• If our projections lead us to believe that
  inflation six to eight quarters in the future
  will be lower than targeted, then we will tend to
  ease monetary conditions today to keep projected
  inflation within the inflation-control bands.

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How Successful has the BoC Been?