A central bank announces a 2% inflation target. Wage contracts are signed based on 2% expected inflation. The bank now faces a choice: deliver 2% as promised, or deviate to 4% to gain a short-run output boost. If wage-setters are rational and understand the bank's incentives, what is the equilibrium outcome?
A2% inflation, as rational agents trust the announced commitment and the bank delivers on it
B4% inflation with a short-run output gain, as the bank exploits the surprise to boost employment
CHigher inflation with no output gain, as rational agents anticipate the deviation and set wages accordingly
DDeflation, as the bank overcorrects to re-establish credibility after missing its target
This is the inflation bias result. Rational wage-setters anticipate that the bank has an incentive to deviate, so they refuse to set wages at 2% — they embed the bank's temptation level (4% or whatever it is) into their expectations. The bank then faces a grim choice: deliver 4% as expected (no surprise, no output gain) or deliver 2% and cause a contraction. The Nash equilibrium is elevated, stable inflation with no output benefit — the worst of both worlds. The key is that rational expectations neutralize the policy temptation.
Question 2 Multiple Choice
Which of the following institutional arrangements best addresses the root cause of time inconsistency in monetary policy?
ARequiring the central bank governor to publicly pledge low inflation at each meeting, creating reputational accountability
BGiving the central bank legal independence from the government and a clear inflation target, making deviation costly and observable
CRequiring unanimous board votes before any rate change, slowing the bank's ability to create surprise inflation
DPublishing detailed meeting minutes so the public can monitor the bank's reasoning, reducing information asymmetry
Time inconsistency is a structural problem: the bank's optimal policy after others have committed differs from what it would optimally announce. Promises and transparency (options A and D) help at the margin but don't change the underlying incentive structure. Independence combined with a transparent target changes the game: deviation becomes publicly observable and costly to the bank's institutional reputation and mandate. This is the Kydland-Prescott / Barro-Gordon insight — solutions must alter incentives, not just intentions.
Question 3 True / False
In the time-inconsistency equilibrium, rational agents end up with higher inflation but no better employment outcomes than if the central bank had simply committed credibly to its announced low-inflation target.
TTrue
FFalse
Answer: True
This is the inflation bias result. Because rational agents anticipate the bank's temptation, they set wages and prices at the higher expected inflation level. When the bank delivers that higher inflation, there is no element of surprise, so there is no real wage reduction, no employment boost — just higher inflation than society actually wants. If the bank could credibly commit to 2%, agents would set wages at 2%, and the bank would deliver 2% — everyone is better off. The equilibrium inflation is a pure loss from the inability to commit.
Question 4 True / False
Time inconsistency in monetary policy can be fully resolved if central bank governors publicly promise to maintain low inflation and are credible, charismatic communicators.
TTrue
FFalse
Answer: False
This misses the structural nature of the problem. Time inconsistency is not a failure of communication or sincerity — it is a strategic trap. Even a governor who genuinely wants low inflation faces the temptation to deviate once wages are set, and rational agents know this. Promises are cheap: what matters is whether deviation is costly. Only institutional changes (independence, inflation targeting with accountability, conservative central bankers whose preferences genuinely differ) alter the incentive structure. Credibility is earned through demonstrated commitment backed by institutions, not through rhetoric.
Question 5 Short Answer
Explain why a central bank that genuinely wants low inflation might still produce an inflation bias, even if all actors are fully rational.
Think about your answer, then reveal below.
Model answer: The problem is dynamic inconsistency between what the bank wants to announce and what it wants to do once others have committed. Once wage contracts are signed based on a low-inflation announcement, the bank faces a temptation: creating surprise inflation reduces real wages, boosts employment, and raises output in the short run — benefits the bank values. Rational agents foresee this temptation and refuse to believe the announcement, instead setting wages at the higher level the bank will actually deliver. The bank cannot credibly commit to low inflation without institutional constraints that make deviation costly, so the equilibrium is elevated inflation with no output gain.
The key insight is that the bank's optimal policy changes depending on whether others have already committed. Before wages are set, the bank prefers to announce 2% (signaling low inflation expectations) and deliver 2%. After wages are set at 2%, the bank prefers to deliver 4% (exploiting the temporary real wage reduction). Rational agents solve this game and embed the higher expected inflation into their contracts, producing inflation bias as the only time-consistent equilibrium.