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Dealing with time-inconsistency: Inflation targeting vs. exchange rate targeting

Author

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  • J. Scott Davis
  • Ippei Fujiwara
  • Jiao Wang
Abstract
Abandoning an objective function with multiple targets and adopting 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.

Suggested Citation

  • J. Scott Davis & Ippei Fujiwara & Jiao Wang, 2017. "Dealing with time-inconsistency: Inflation targeting vs. exchange rate targeting," CAMA Working Papers 2017-54, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
    • Handle: RePEc:een:camaaa:2017-54
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    Cited by:

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    More about this item

    Keywords

    Time-inconsistency; Commitment; Inflation target; Exchange rate peg; Tie-one’s-hands;
    All these keywords.

    JEL classification:

    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General
    • E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)
    • F40 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - General

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