Question

Dual mandates may be unable to avoid the time inconsistency problem. True False

Answer 1

True

Explanation :-

First let us see what is the problem of time inconsistency and how it affects our economy then we will see how Dual mandates may be unable to avoid the time inconsistency is wrong statement or correct?

In economics, time-inconsistency is the problem that arises when a decision maker, especially a policymaker, prefers one policy in advance but later enacts a different one. Deciding among alternative policies at different points in time can vary depending on expected utility anomalies; thus people sometimes make time-inconsistent decisions.

We face this issue every day. Consider, for example, a smoker: there is a conflict between the pleasure of cigarette and the preservation of good health. When the promise of a cigarette is substantially delayed, say one year from now, a rational person will choose to preserve his health; but if one’s reward is imminent, it will be difficult for him to restrain.

Similarly, we can apply the same logic to the time value of money.

Would you rather be given $500 today or $505 in one week?

Now, would you rather be give $500 in one year or $505 in one year and one week?

Chances are that you prefer to receive $505 in one year and one week, whereas in the first case your choice was not that definitive. A rational person would choose the same option for both questions; nonetheless, we see that delaying the outcomes leads to different choices (Stephen Hoch and George Loewenstein).What could be the reason of this inconsistency?

Miscalculation: we do not realize, when asking $10 more over a two-week period, that this represents a 1,191% interest rate over one year.
Competition for limited resources: when several people are competing for a common objective, it is better to act now because the opportunity may not be available tomorrow; this can lead to inconsistent behavior.
Impatience, or present-biased: in the future, willpower is irrelevant— we always do the right thing. In conducting their study, Read and van Leeuwen asked a group of people whether they would prefer to to eat snacks or fruits during their lunch break one week before meeting them: 75% chose the fruits. During the actual meeting a week later, twenty minutes before the break people were given the choice to change their minds, and 75% switched their choice to the chocolate bars.

The Federal Reserve operates under what is known as a dual mandate: i.e., legislation
directs the Federal Reserve to promote both price stability and full employment. In contrast,
many other central banks such as the Bank of Canada, the Bank of England and the European
Central Bank operate under a hierarchical mandate in which price stability is the primary
objective of the central bank, and other objectives such as full employment are pursued only as
long as they are consistent with price stability.
As monetary theorists, we may not see a real difference between the dual and
hierarchical mandates because as long as full employment is defined as the natural rate of
employment, there is no inconsistency between achieving price stability and the natural rate of
employment.7
However, in practice, there is a substantial difference between these two
mandates because the public, politicians and even some economists may view a hierarchical
mandate as putting too much emphasis on inflation control and not enough on reducing output
fluctuations. Indeed, Lawrence Meyer (2004) has argued, and I think rightfully, that the
American public and politicians strongly support a dual mandate and would be unwilling to
change the Federal Reserve objectives to a hierarchical mandate. Americans are not the only
ones think this way. I would wager that if you asked the average person in most countries
which mandate for a central bank they believed is more appropriate, they would choose a dual
rather than a hierarchical mandate.
Because inflation targeting involves a target for inflation but not for output or
unemployment, at first glance, inflation targeting seems to be inconsistent with a dual mandate
and opens the door to accusations that inflation targeters are, as Mervyn King (1997) put it,
“inflation nutters”: i.e., that they only care about minimizing inflation fluctuations. However,
concerns that inflation targeting is inconsistent with the dual mandate are unfounded.
Nonetheless, inflation-targeting central banks or those contemplating inflation need to make
clearer that their objectives are fully consistent with the dual mandate in order to retain support for central bank independence and inflation targeting.
Inflation targeting theory, as represented by canonical models such as Svensson (1997),
clearly shows that inflation targeting is not only not inconsistent with the dual mandate, but
indeed is based on it: an inflation-targeting central bank would have as its objective the
minimization of a weighted average of the variability of both output and inflation fluctuations,
which is exactly what the dual mandate specifies. The inflation-targeting regime that results
from this analysis is one in which the central bank does not try to hit the inflation target over the
policy horizon if inflation is far from the target; instead the approach to the inflation target is
more gradual. Svensson has called this strategy “flexible inflation targeting”, and as argued by
Bernanke, et al.(1999), this is exactly what inflation targeting central banks do in practice.
However, to preserve or obtain support for inflation targeting, central banks need to make
clear that they do indeed care about output fluctuations and that they are pursuing a dual
mandate. Unfortunately, the reality is that central bankers, whether they inflation target or not,
are extremely reluctant to discuss concerns about output fluctuations even though their actions
show that they do care about them. This lack of transparency is the “the dirty little secret of
central banking”. One remarkable manifestation of this occurred in August of 1994 at the
Federal Reserve Bank of Kansas City’s Jackson Hole Conference, when Alan Blinder, then the
vice-chairman of the FOMC, had the temerity to mention that a short-run tradeoff between
output and inflation exists and that therefore monetary policy should be concerned about
minimizing output as well as inflation fluctuations. Blinder was then pilloried by many central
bankers and in the press, with a Newsweek columnist declaring that he was not qualified to be
a central banker.8
The discomfort that central bankers as a group have with discussing that
they care about output fluctuations, even though they surely do, is also illustrated by a story
that Larry Meyer (2004) tells about a conversation that he had with two leading central bankers
shortly after he became a governor at the Fed. They advised him that “Good central bankers
never admit they pursue stabilization policy. Central bankers fear that if they are explicit about the need to minimize output
fluctuations as well as inflation fluctuations, politicians will use this to pressure the central
bank to pursue a short-run strategy of overly expansionary policy that will lead to poor long-
run outcomes. The response to this problems is that central bankers engage in a “don’t ask,
don’t tell” strategy.
Besides being the height of non-transparency, the “don’t ask, don’t tell strategy” gives
the impression that central bankers don’t believe in the dual mandate. Suspicions that the
central bank has preferences that are clearly inconsistent with the public’s can erode support
both for central bank independence and inflation targeting. The case for the central bank to
discuss that it does care about reducing output fluctuations is quite strong. But how can
central banks do this?
One answer is that a central bank can announce that it will not try to hit its inflation
target over too short a horizon because this would result in unacceptably high output losses,
especially when the economy gets hit by shocks that knock it substantially away from its long-
run inflation goal. Inflation targeting banks have been moving in this direction: for example,
the Reserve Bank of New Zealand has modified its inflation-targeting regime to lengthen the
horizon over which it tries to achieve its inflation target.10
Although inflation-targeting central banks have lengthened the horizon for their targets
to two years or so, with the Bank of England being a prominent example, this still does not
completely solve the problem because it gives the impression that the horizon for inflation
targets is fixed, which is not sufficiently flexible if a dual mandate is being followed.11 Up to
now, the use of a specific horizon like two years has not been a problem for inflation targeting
in advanced countries like the United Kingdom, because inflation has not been subject to large shocks, so that inflation has remained close to the target level. In this case, having the horizon
for the target equal to the two-year horizon at which policy changes take effect is consistent
with optimal policy. However, as Svensson (1997) has shown, when there is a concern about
output fluctuations and the inflation rate is shocked sufficiently away from its long-run target,
the path for the medium-term inflation target horizon needs to be modified.
A striking example of how large shocks to inflation can be handled occurred in Brazil
recently (Fraga, Goldfajn and Minella, 2003). Brazil experienced a major exchange rate shock
in 2002 because of concerns that the likely winner in the presidential election would pursue
populist policies that would lead to currency depreciation. The resulting depreciation then led
to a substantial overshoot of the Brazilian inflation target. In January 2003, the Banco Central
do Brasil announced a procedure for how it would modify its inflation targets. First, the
central bank estimated the regulated-price shock to be 1.7%. Then taking into account the
nature and persistence of the shocks, it estimated the inertia from past shocks to be 4.2% of
which 2/3 was to be accepted, resulting in a futher adjustment of 2.8%. Then the central bank
added these two numbers to the previously announced target of 4% to get an adjusted target for
2003 of 8.5% (=4% + 1.7% + 2.8%). The central bank then announced the adjusted target
in an open letter sent to the Minister of Finance in January 2003, which explained that getting
to the non-adjusted target of 4% too quickly would entail far too high a loss of output.
Specifically, the announcement indicated that an attempt to achieve an inflation rate of 6.5% in
2003 would be expected to entail a decline of 1.6% of GDP, while trying to achieve the
previous target of 4% would be expected to lead to an even larger decline of GDP of 7.3%.
The procedure followed by the Banco Central do Brasil had tremendous transparency,
both in articulating why the inflation target was missed and also in explaining why the new
target path for inflation was chosen. The discussion of alternative target paths, with the
explanation that lower inflation paths would lead to large output losses demonstrated that the
central bank did indeed care about output fluctuations, thus demonstrating that it was not an
“inflation nutter” and that its concern about output losses was aligned with similar concerns by
the public.
Even though advanced economies have not yet had inflation shocks of the magnitude that Brazil has recently experienced, outlining the procedures that they will use to respond to
any future adverse shocks provides a vehicle for them to explain that they do indeed care about
output fluctuations.12 By announcing that they would do what the Brazilians have done if a
situation arose in which inflation were shocked substantially away from the long-run goal,
central bankers can get the dirty little secret out of the closet that they do have an appropriate
concern about output fluctuations. Yet , they will still be able to assure the public that they
continue to worry about the long-run and the importance of achieving price stability. A
procedure like the one followed by Brazil conveys that the central bank cares about output
fluctuations in a forward-looking context because it highlights decisions that the central bank
will make about the future path of inflation and the horizon over which inflation will return to
the target. It therefore continues to make clear that the central bank is focused on output
fluctuations in a longer-run and not a short-run context, which is necessary for minimizing the
time-inconsistency problem.
Monetary authorities can further the public's understanding that they care about
reducing output fluctuations and that they are following a dual mandate by emphasizing that
monetary policy needs to be just as vigilant in preventing inflation from falling too low as it is
from preventing it from being too high. They can do this (and some central banks have) by
explaining that an explicit inflation target may help the monetary authorities stabilize the
economy because they can be more aggressive in easing monetary policy in the face of
negative demand shocks to the economy without being concerned that this will cause a blowout
in inflation expectations. However, in order to keep the communication strategy clear, the
explanation of a monetary policy easing in the face of negative demand shocks needs to
indicate that it is consistent with the preservation of price stability.
In addition, central banks can also clarify that they care about reducing output fluctuations by indicating that when the economy is very far below any reasonable measure of
potential output, they will take expansionary actions to stimulate economic recovery. In this
case, measurement error of potential output is likely to swamped by the size of the output gap
so it is far clearer that expansionary policy is appropriate and that inflation is unlikely to rise
from such actions. In this situation, the case for taking actions to close the output gap is much
stronger and does not threaten the credibility of the central bank in its pursuit of price stability.