When the Government is in charge of obtaining low inflation it is not always credible, this is due to the preferences of a Government. The best way to show this is as a simple game. We will assume that the Government chooses inflation and the private sector obviously set the expected rate of inflation. Looking at preferences the Government firstly prefer a low level of unemployment, and then the next preference is a low level of inflation. The private sector do not care if inflation is high or if it is low, only that its expected inflation is equal to actual inflation (so it can set wage demands accordingly etc.). These preferences have been put into the table and graph below.
The Governments favoured result is at B where unemployment is at its lowest, then A where inflation is low and unemployment is at its natural rate (when Π = EΠ Unemployment is at its Natural rate.), then D where inflation is high and unemployment is at its natural rate and then finally C where unemployment is at its highest.
Order of preferences B>A>D>C.
The private sector prefers A & D equally, and dislikes B & C equally,
Order of Preferences A=D>B=C.
The Government wants to achieve B (low unemployment) this is when Inflation is high and expected inflation is low, this can not be achieved in the long run as the private sector are adverse to getting their inflation expectations wrong. If the Government say they are going to keep inflation low and the private sector believe this and set their inflationary expectations low it would be consistent with Governments preferences to set inflation high (achieve B), the private sector will realise this and set their expectations high to reach D.
If the private sector set their expectations high the governments optimal strategy is to set inflation high (achieve D), in both cases the outcome D will be reached. The best obtainable strategy (where inflationary expectations are equal to inflation) would be strategy A, unemployment is at the same levels as D but inflation is lower. This is achieved where expected and actual inflation are low. At this point it would be in the Governments interests to tolerate high inflation to achieve lower unemployment (B), as before the private sector is adverse to this and sets expectations accordingly (D).
In this case the Governments policy is not credible, it says it will set inflation low but when expectations are at this level it is in there best interests to tolerate inflation in order to achieve their preferred outcome of low unemployment. As the final outcome D has the same unemployment but a higher inflation than the best obtainable outcome A, we can say this lack of credibility in the Governments policy has led to a Inflation Bias.
In 1992 the Government attempted to remove this inflation Bias by setting an inflation target, it committed itself to keeping inflation between 1% and 4%, in 1997 it went further to increase its credibility by making the Bank of England independent via the introduction of the Monetary Policy Committee (MPC). The Committee was given the following remit:
- an inflation target for RPI excluding mortgage payments of 2.5 per cent;
- without prejudice to the objective of price stability, the Bank will support the Government's economic policy. including its objectives for growth and employment;
-
if inflation is more than 1 percentage point higher or lower than the target, the Bank will be required to publish an open letter explaining why inflation has deviated from the target and what actions it intends to take to get it back to target.
This has again strengthened the credibility of the Governments monetary policy of low inflation, if the MPC has low inflation as its only objective its preferences can be written as below.
Notice the private sector has the same preferences as before (A&D>B&C), but the MPC has a target which states its only interest is to achieve low inflation (it’s preference for low inflation is strictly dominant over choosing high inflation). No matter what the private sector chooses the MPC will always choose low inflation, the private sectors preferences are that expected inflation matches actual inflation and as such will choose Expected inflation to be low. The outcome will now always be A (on previous graph), by giving the Bank of England independence the Government has made its monetary policy more credible and removed the inflation Bias.
The inflation bias is removed only if the MPC is truly independent, if the Government can influence the MPC to have the same preferences as itself the monetary policy remains un-credible and the inflationary bias persists.
The Government has gone out of its way to ensure its Monetary Policy is robust, it has a clear and Credible target (the MPC remit), it is Transparent and Flexible. This a
Select Committee on Monetary Policy Committee of the Bank of England, 1999. http://www.parliament.the-stationery-office.co.uk/pa/ld199899/ldselect/ldmon/96/9603.htm#a2
In "The Inflation Target and Remit for the Monetary Policy Committee: Background notes" published by the Treasury in June 1997.
