The Credibility of Monetary Policy: A Survey of the Literature with Some Simple Applications to Canada

Abstract

Since Kydland and Prescott published their famous article on rules versus discretion in 1977, the literature on the time-inconsistency problem of economic policy expanded rapidly. While much of the literature is highly technical and can seem esoteric, there is generally an underlying practicality to it, especially in the recent literature on institutional reform. Accordingly, the purpose of this paper is to survey the literature from the perspective of a central bank practitioner. We have three specific objectives. The first is to get a sense of why the credibility problem is important for the economy and for policymakers. The second is to draw some lessons from the literature that a monetary authority can use to enhance the credibility of its policy. And the third is to apply some simple tests of credibility from the literature to assess whether initiatives by the Bank of Canada to make the conduct of monetary policy more transparent and predictable have been successful. The paper is divided into three main parts; each devoted to one of these objectives. There is also a brief concluding section.

JEL Classification: E, F3