Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Creating a credible commitment


Central to understanding why you’d tie your own hands, seemingly restricting your room for manoeuvre, is the concept of credible commitment: committing to something in a way that is believed by others.

The advantage is that when politicians have their discretion taken away from them, they can’t break the rules and submit to other, perhaps short-term or self-interested, imperatives, even if they want to.

The question is: how does a policy maker go about making a commitment credible? A number of ways have been proposed, but here we consider the case of monetary policy. The problem with discretionary monetary policy is that policy makers have an incentive to take advantage of the Phillips curve relationship in order to reduce unemployment below the natural rate. Private sector agents understand this, which ultimately leads to inflation bias (higher inflation without any reduction in unemployment) (see the preceding section and earlier Figure 13-1).

In order to commit credibly to low inflation, the central bank can try the following:


Write it into the law/constitution: The law specifies a precise rule that the central bank must follow. An example is increasing the money supply by 2 per cent every year, or even not at all. In this way the central bank loses its ability to deviate from the announced policy of low inflation.

Become independent: Politicians then no longer have control or influence over monetary policy. The idea is that politicians may want to reduce unemployment in the short run in order to improve their election prospects. When monetary policy is conducted independent of political considerations, the hope is that the central bank sees no need to reduce

unemployment artificially. We discuss this concept further in the following section.


Appoint a ‘conservative’ central banker: This is an interesting one: it implies appointing policy makers who are known to really dislike inflation. Sometimes these types of people are called ‘inflation hawks’ – they hate inflation and everyone knows it. The reason for appointing them is clear: people trust them to keep inflation low.


Pay for performance: Make the salary of policy makers depend entirely on how well they perform in keeping inflation low; this really makes them ‘put their money where their mouth is’. If they don’t follow through on their announcement, they simply don’t get paid!

The intention behind all of these approaches is to make the central bank’s commitment to low inflation credible and to thereby reduce people’s inflation expectations, which in turn reduces actual inflation. Out of these different strategies, the one that has been taken up most widely and that is seen as the most successful is central bank independence. We look at that concept in more detail in the following section.