Credibility and reputation

The issues of credibility and reputation of monetary authorities were introduced by the "New classical economists", in order to develop additional arguments in favour of monetary policy rules and against the use of discretionary policies. Their main goal was to show that an "inflation bias" emerges in cases where monetary policy is discretionary. Monetary authorities are said to be credible if private agents believe in their commit- ment to price stability. Kydland and Prescott (1977) showed that it is in the best interests of central banks to announce a low-inflation policy and then, if private agents believe in the policy announced, to switch to a higher-inflation policy in order to temporarily reduce the rate of unemployment. As a matter of consequence, central banks will have a credibility issue, because rational agents will not believe them.

This credibility issue raised by Kydland and Prescott (1977) can only arise under very restrictive theoretical circumstances: central banks have to make their decision first before private agents can react, the game needs to be a one-shot one, and agents as well as the central bank must have full information and must not cooperate.

When the game is repeated and/or when information is asymmetric, central banks will need to take care of their reputation, an issue raised by Barro and Gordon (1983). Reputation can be broadly defined as the monetary authorities' credibility over the long run - whether or not agents will believe in their announcements when the game is repeated, on the basis of earlier actions. In the repeated game of Barro and Gordon (ibid.), reputation matters because a monetary authority exercising discretion can be "punished" by private agents in further stages of the game. As a matter of consequence, the monetary authorities must, in each period, weigh up the gains of cheating (which induces a lower unemployment rate) against the costs in terms of "inflation bias".

Another issue in Barro and Gordon (1983) is that agents do not know what kind of monetary authorities they are facing: a "hawk" (very sensitive to inflation) or a "dove" (more permissive to inflation). Over the various periods of the game, private agents will have to analyse the policy announcements and measures of the central bank in order to "extract" information about its true nature. Establishing a good reputation is for mon- etary authorities a way of avoiding this "signal extraction" issue (raised by Blackburn, 1992) and as a matter of consequence avoiding a possible inflation bias.

To sum up, in Barro and Gordon's (1983) repeated game-theoretic framework, reputa- tion can be built by repetition or most preferably using monetary policy rules; the main benefit of a good reputation is credibility; and reputation can be damaged when mon- etary authorities cheat in order to (temporarily) reach a lower unemployment rate.

The economic framework used to deal with credibility and reputation issues can be heavily criticized. These issues can only arise in a "New classical" theoretical model, in which the long-run Phillips curve is vertical and expectations are formed in a forward- looking manner - and therefore monetary authorities can reduce the rate of unemploy- ment below its natural rate only at the expense of an "inflation bias". However, there are serious doubts about the existence of a natural rate of unemployment (see Stanley, 2005; Lang, 2009). There are also doubts about the idea that unions would bargain wages on the basis of expected inflation rather than recent inflation. The possibility for monetary authorities to create an "inflation surprise" has also raised serious debates, as it can take years for monetary policies to produce their effects.

As underlined by Forder (2001), the game-theoretic intuitions behind the "credibility and reputation" view have been imported from industrial economics. In rivalry between oligopolists, threats of fighting entry to market are cheap talk. But are private agents and monetary authorities in a similar relationship? Do monetary authorities really think it is in their best interest to fool private agents? Do private agents really act to punish the central bank?

At the end of the day, the need for a central bank to acquire a good reputation is strongly connected to the ideas that the main goal of monetary policy should be to mini- mize the "inflation bias"; that inflation is an evil per se; and that its main cause is wage increases. This whole set of ideas is highly debatable, especially when the central bank has other policy objectives (like reducing unemployment) or, in times of crises, when the main issue is the risk of deflation rather than inflation.

See also:

Asymmetric information; Central bank credibility; Central bank independence; Inflation; Phillips curve; Rules versus discretion; Time inconsistency.