Dealing with Time-Inconsistency: Inflation Targeting vs. Exchange Rate Targeting

38 Pages Posted: 19 Mar 2018

See all articles by J. Scott Davis

J. Scott Davis

Federal Reserve Banks - Federal Reserve Bank of Dallas

Ippei Fujiwara

Australian National University (ANU) - Crawford School of Public Policy

Jiao Wang

University of Melbourne - Melbourne Institute of Applied Economic and Social Research

Multiple version iconThere are 2 versions of this paper

Date Written: March 15, 2018

Abstract

Abandoning an objective function with multiple targets and adopting a single mandate can be an effective way for a central bank to overcome the classic time-inconsistency problem. We show that the choice of a particular single mandate depends on an economy’s level of trade openness and the credibility of the central bank. We begin with reduced form empirical results which show that as central banks become less credible they are more likely to adopt a pegged exchange rate, and crucially, the tendency to peg depends on trade openness. Then in a model where the central bank displays “loose commitment” we show that as central bank credibility falls, they are more likely to adopt either an inflation target or a pegged exchange rate. A relatively closed economy would adopt an inflation target to overcome the time-inconsistency problem, but a highly open economy would prefer an exchange rate peg.

Keywords: Time-inconsistency, commitment, inflation target, exchange rate peg, tie-one’s-hands

JEL Classification: E50, E30, F40

Suggested Citation

Davis, J. Scott and Fujiwara, Ippei and Wang, Jiao, Dealing with Time-Inconsistency: Inflation Targeting vs. Exchange Rate Targeting (March 15, 2018). Melbourne Institute Working Paper No. 03/18. Available at SSRN: https://ssrn.com/abstract=3141598 or http://dx.doi.org/10.2139/ssrn.3141598

J. Scott Davis

Federal Reserve Banks - Federal Reserve Bank of Dallas ( email )

2200 North Pearl Street
PO Box 655906
Dallas, TX 75265-5906
United States

Ippei Fujiwara

Australian National University (ANU) - Crawford School of Public Policy ( email )

ANU College of Asia and the Pacific
J.G. Crawford Building #132 Lennox Crossing
Canberra, Australian Capital Territory 0200
Australia

Jiao Wang (Contact Author)

University of Melbourne - Melbourne Institute of Applied Economic and Social Research ( email )

Level 5, FBE Building, 111 Barry Street
Parkville, Victoria 3010
Australia

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