《货币银行学》课程教学资源（文献资料）WHAT SHOULD CENTRAL BANKS DO

WHATSHOULDCENTRALBANKSDO?byFrederic S. MishkinGraduateSchool ofBusiness,ColumbiaUniversityandNationalBureauofEconomicResearchUris Hall 619Columbia UniversityNewYork,NewYork10027Phone:212-854-3488,Fax:212-316-9219720-2630E-mail:fsm3@columbia.eduMarch 2000Prepared for the Homer Jones Lecture, Federal Reserve Bank of St. Louis, March 30, 2000I thank Dan Thornton, Bill Poole, Lars Svensson and the participants in the Macro LunchatColumbiaUniversityfortheirhelpful comments.Anyviewsexpressed inthispaperare those of the author only and not those of Columbia University or the NationalBureauofEconomicResearch

WHAT SHOULD CENTRAL BANKS DO? by Frederic S. Mishkin Graduate School of Business, Columbia University and National Bureau of Economic Research Uris Hall 619 Columbia University New York, New York 10027 Phone: 212-854-3488, Fax: 212-316-9219720-2630 E-mail: fsm3@columbia.edu March 2000 Prepared for the Homer Jones Lecture, Federal Reserve Bank of St. Louis, March 30, 2000. I thank Dan Thornton, Bill Poole, Lars Svensson and the participants in the Macro Lunch at Columbia University for their helpful comments. Any views expressed in this paper are those of the author only and not those of Columbia University or the National Bureau of Economic Research

I.IntroductionIn the last twenty years, there has been substantial rethinking about how centralbanks should do their job.This rethinking has led to major changes in how centralbanks operate, and we are now in an era in which central banks in many countriesthroughout the world have had notable success -- keeping inflation low, while theireconomies experiencerapid economic growth.In this lecture,I outline what we thinkwe have learned about how central banks should be set up to conduct monetary policyand then apply these lessons to see if there is room for institutional improvement in thewaytheFederal Reserve operates.The lecture begins by discussing seven guiding principles for central banks andthen uses these principles to outline what the role of central banks should be.Thisframework is then used to see how the institutional features of the Fed measures up. Iwill take theviewthat despite the Fed's extraordinarily successful performance in recentyears,weshould notbe complacent.Changes inthewaytheFedis setupto conduct itsbusiness may be needed to help ensure that the Fed continues to be as successful in thefuture.II.Guiding Principles forCentral BanksRecent theorizing in monetary economics suggests seven basic principles that canserve as useful guides for central banks to help them achieve successful outcomes intheirconductofmonetarypolicy:1)price stabilityprovides substantialbenefits,2)fiscalpolicy should be aligned withmonetary policy,3) time inconsistencyis a seriousproblemtobeavoided,4)monetarypolicy should beforward looking,5)accountabilityis a basic principle of democracy, 6) monetary policy should be concerned about outputas well as pricefluctuations, and 7) the most serious economic downturns are associatedwith financial instability.We look at each oftheseprinciples in turn.1

1 I. Introduction In the last twenty years, there has been substantial rethinking about how central banks should do their job. This rethinking has led to major changes in how central banks operate, and we are now in an era in which central banks in many countries throughout the world have had notable success - keeping inflation low, while their economies experience rapid economic growth. In this lecture, I outline what we think we have learned about how central banks should be set up to conduct monetary policy and then apply these lessons to see if there is room for institutional improvement in the way the Federal Reserve operates. The lecture begins by discussing seven guiding principles for central banks and then uses these principles to outline what the role of central banks should be. This framework is then used to see how the institutional features of the Fed measures up. I will take the view that despite the Fed's extraordinarily successful performance in recent years, we should not be complacent. Changes in the way the Fed is set up to conduct its business may be needed to help ensure that the Fed continues to be as successful in the future. II. Guiding Principles for Central Banks Recent theorizing in monetary economics suggests seven basic principles that can serve as useful guides for central banks to help them achieve successful outcomes in their conduct of monetary policy: 1) price stability provides substantial benefits, 2) fiscal policy should be aligned with monetary policy, 3) time inconsistency is a serious problem to be avoided, 4) monetary policy should be forward looking, 5) accountability is a basic principle of democracy, 6) monetary policy should be concerned about output as well as price fluctuations, and 7) the most serious economic downturns are associated with financial instability. We look at each of these principles in turn

1.PriceStabilityProvides SubstantialBenefitsto theEconomy.In recentyears a growing consensus has emerged that price stability -- a low and stable inflationrate --provides substantial benefits to the economy.Price stability preventsoverinvestment in the financial sector, which in a high inflation environment expand toprofitably act as a middleman to help individuals and businesses escape some of thecosts of inflation.1 Price stability lowers the uncertainty about relative prices and thefuture price level, making it easier for firms and individuals to make appropriatedecisions, thereby increasing economic efficiency? Price stability also lowers thedistortionsfrom the interaction ofthetax system and inflation.3All of these benefits of price stability suggest that low and stable inflation canincrease the level of resources productively employed in the economy,and might evenhelp increase the rate of economic growth. While time-series studies of individualcountries and cross-national comparisons of growth rates are not in total agreement,there is a consensus that inflation is detrimental to economic growth, particularly wheninflation is at high levels.4 Therefore, both theory and evidence suggest that monetarypolicy should focus on promoting price stability.2.Align Fiscal Policy with Monetary Policy.One lesson from the"unpleasantmonetarist arithmetic"discussed in Sargent and Wallace (1981)and therecent literatureon fiscal theories ofthepricelevel (Woodford,1994 and1995)is that irresponsiblefiscalpolicymay makeitmoredifficult for themonetary authorities to pursue price stability.Large government deficits may put pressure on the monetary authorities to monetizethe debt, thereby producing rapid money growth and inflation. Restraining the fiscalauthorities from engaging in excessive deficit financing thus aligns fiscal policy withmonetary policy and makes it easier for the monetary authorities to keep inflationundercontrol'For example, see English (1996).2E.g., see Briault (1995),E.g., see Fischer (1994) and Feldstein (1997).tSee the survey in Anderson and Gruen (1995)2

2 1. Price Stability Provides Substantial Benefits to the Economy. In recent years a growing consensus has emerged that price stability - a low and stable inflation rate - provides substantial benefits to the economy. Price stability prevents overinvestment in the financial sector, which in a high inflation environment expand to profitably act as a middleman to help individuals and businesses escape some of the costs of inflation.1 Price stability lowers the uncertainty about relative prices and the future price level, making it easier for firms and individuals to make appropriate decisions, thereby increasing economic efficiency.2 Price stability also lowers the distortions from the interaction of the tax system and inflation.3 All of these benefits of price stability suggest that low and stable inflation can increase the level of resources productively employed in the economy, and might even help increase the rate of economic growth. While time-series studies of individual countries and cross-national comparisons of growth rates are not in total agreement, there is a consensus that inflation is detrimental to economic growth, particularly when inflation is at high levels.4 Therefore, both theory and evidence suggest that monetary policy should focus on promoting price stability. 2. Align Fiscal Policy with Monetary Policy. One lesson from the "unpleasant monetarist arithmetic" discussed in Sargent and Wallace (1981) and the recent literature on fiscal theories of the price level (Woodford, 1994 and 1995) is that irresponsible fiscal policy may make it more difficult for the monetary authorities to pursue price stability. Large government deficits may put pressure on the monetary authorities to monetize the debt, thereby producing rapid money growth and inflation. Restraining the fiscal authorities from engaging in excessive deficit financing thus aligns fiscal policy with monetary policy and makes it easier for the monetary authorities to keep inflation under control. 1 For example, see English (1996). 2E.g., see Briault (1995). 3E.g., see Fischer (1994) and Feldstein (1997). 4 See the survey in Anderson and Gruen (1995)

3.Time Inconsistency is a Serious Problem to be Avoided. One of the keyproblems facing monetary policymakers is the time-inconsistency problem described byCalvo (1978), Kydland and Prescott (1978) and Barro and Gordon (1983). The time-inconsistency problem arises because there are incentives for a policymaker to try toexploit the short-run tradeoff between employment and inflation to pursue short-runemployment objectives, even though the result ispoor long-run outcomes.Expansionary monetary policy will produce higher growth and employment in theshort-run and so policymakers will be tempted to pursue this policy even though it willnot produce higher growth and employment in the long-run because economic agentsadjust their wage and price expectations upward to reflect the expansionary policy.Unfortunately,however, expansionary monetary policywill lead tohigherinflation inthelong-run, with its negative consequencesfortheeconomy.McCallum (1995) points out that the time-inconsistency problem by itself doesnot imply thata central bank will pursue expansionary monetary policy whichleads toinflation. Simply by recognizing the problem that forward-looking expectations in thewage- and price-setting process creates for a strategy of pursuing expansionarymonetary policy, central banks can decide not to play that game.From my first-handexperience as a central banker, I can testify that central bankers are very aware of thetime-inconsistency problem and are indeed extremely adverse to falling into a timeinconsistency trap.However, even if central bankers recognize the problem, there stillwill bepressures onthecentral bank to pursueoverly expansionarymonetarypolicybypoliticians. Thus overly expansionary monetary policy and inflation may result, so thatthe time-inconsistency problem remains. The time-inconsistency problem is just shiftedback one step;its source is not in the central bank, but rather resides in the politicalprocess.Thetime-inconsistencyliteraturepoints outbothwhytherewill bepressuresoncentral banks to pursue overly expansionary monetary policy and why central bankswhose commitment to price stability is in doubt are more likely to experience higherinflation. In order to prevent high inflation and the pursuit of a suboptimal monetarypolicy,monetary policy institutions need to be designed in order to avoid the time-inconsistencytrap.4. Monetary Policy Should Be Forward Looking. The existence of long lags3

3 3. Time Inconsistency is a Serious Problem to be Avoided. One of the key problems facing monetary policymakers is the time-inconsistency problem described by Calvo (1978), Kydland and Prescott (1978) and Barro and Gordon (1983). The time￾inconsistency problem arises because there are incentives for a policymaker to try to exploit the short-run tradeoff between employment and inflation to pursue short-run employment objectives, even though the result is poor long-run outcomes. Expansionary monetary policy will produce higher growth and employment in the short-run and so policymakers will be tempted to pursue this policy even though it will not produce higher growth and employment in the long-run because economic agents adjust their wage and price expectations upward to reflect the expansionary policy. Unfortunately, however, expansionary monetary policy will lead to higher inflation in the long-run, with its negative consequences for the economy. McCallum (1995) points out that the time-inconsistency problem by itself does not imply that a central bank will pursue expansionary monetary policy which leads to inflation. Simply by recognizing the problem that forward-looking expectations in the wage- and price-setting process creates for a strategy of pursuing expansionary monetary policy, central banks can decide not to play that game. From my first-hand experience as a central banker, I can testify that central bankers are very aware of the time-inconsistency problem and are indeed extremely adverse to falling into a time￾inconsistency trap. However, even if central bankers recognize the problem, there still will be pressures on the central bank to pursue overly expansionary monetary policy by politicians. Thus overly expansionary monetary policy and inflation may result, so that the time-inconsistency problem remains. The time-inconsistency problem is just shifted back one step; its source is not in the central bank, but rather resides in the political process. The time-inconsistency literature points out both why there will be pressures on central banks to pursue overly expansionary monetary policy and why central banks whose commitment to price stability is in doubt are more likely to experience higher inflation. In order to prevent high inflation and the pursuit of a suboptimal monetary policy, monetary policy institutions need to be designed in order to avoid the time￾inconsistency trap. 4. Monetary Policy Should Be Forward Looking. The existence of long lags

from monetary policy actions to their intended effects on output and inflation suggeststhat monetary policy should be forward looking. If policymakers wait until undesirableoutcomes on inflation and output fluctuations actually arise, their policy actions arelikely to be counterproductive. For example, by waiting until inflation has alreadyappeared before tighteningmonetary policy,themonetary authorities will betoo late;inflation expectationswill alreadybeembedded intothewageand price-settingprocess,creating an inflation momentum that will be hard to contain. Once the inflation processhas gotten rolling, the process of stopping it will be slower and costlier.Similarly, bywaiting until the economy is already in recession, expansionary policy may kick in wellafter the economy has recovered, thus promoting unnecessary output fluctuations andpossibleinflation.To avoid these problems, monetary authorities must behave in a forward-lookingfashion and act preemptively.For example, if it takes twoyears for monetary policy tohavea significant effect on inflation, then even if inflation is quiescent currently but withan unchanged stance of monetary policy policymakers forecast inflation to rise in twoyears time, then they must act today to head offthe inflationary surge.5.Policymakers Should be Accountable. A basic principle of democracy is thatpublic should have the right to control the actions of the government: in other and morefamous words,"thegovernment should beof the people,bythe people and forthepeople." Thus the public in a democracy must have the capability to "throw the bumsout" or punish incompetent policymakers through other methods in order to controltheir actions. If policymakers cannot beremoved from office or punished in some otherway, this basic principle of democracy is violated.In a democracy, governmentpolicymakers needtobeheld accountabletothepublic.A second reason why accountability of policymakers is important is that it helpsto promote efficiency in government. Making policymakers subject to punishmentmakes it more likely that incompetent policymakers will be replaced by competentpolicymakers and creates better incentives forpolicymakers todo their jobs well.Knowing that they are subject to punishment when performance is poor, policymakerswill strive to get policy right. If policymakers are able to avoid accountability, thentheir incentives to do a good job drop appreciably, making poor policy outcomes morelikely.4

4 from monetary policy actions to their intended effects on output and inflation suggests that monetary policy should be forward looking. If policymakers wait until undesirable outcomes on inflation and output fluctuations actually arise, their policy actions are likely to be counterproductive. For example, by waiting until inflation has already appeared before tightening monetary policy, the monetary authorities will be too late; inflation expectations will already be embedded into the wage and price-setting process, creating an inflation momentum that will be hard to contain. Once the inflation process has gotten rolling, the process of stopping it will be slower and costlier. Similarly, by waiting until the economy is already in recession, expansionary policy may kick in well after the economy has recovered, thus promoting unnecessary output fluctuations and possible inflation. To avoid these problems, monetary authorities must behave in a forward-looking fashion and act preemptively. For example, if it takes two years for monetary policy to have a significant effect on inflation, then even if inflation is quiescent currently but with an unchanged stance of monetary policy policymakers forecast inflation to rise in two years time, then they must act today to head off the inflationary surge. 5. Policymakers Should be Accountable. A basic principle of democracy is that public should have the right to control the actions of the government: in other and more famous words, "the government should be of the people, by the people and for the people." Thus the public in a democracy must have the capability to "throw the bums out" or punish incompetent policymakers through other methods in order to control their actions. If policymakers cannot be removed from office or punished in some other way, this basic principle of democracy is violated. In a democracy, government policymakers need to be held accountable to the public. A second reason why accountability of policymakers is important is that it helps to promote efficiency in government. Making policymakers subject to punishment makes it more likely that incompetent policymakers will be replaced by competent policymakers and creates better incentives for policymakers to do their jobs well. Knowing that they are subject to punishment when performance is poor, policymakers will strive to get policy right. If policymakers are able to avoid accountability, then their incentives to do a good job drop appreciably, making poor policy outcomes more likely

6. Monetary Policy Should be Concerned with Output as Well as PriceFluctuations.Price stability is a means to an end, a healthy economy, and should notbe treated as an end in itself.Thus, central bankers should not be obsessed with inflationcontrol,andbecomewhatMervynKing(1997)hascharacterizedas"inflationnutters"Clearly the public cares about output as well as inflation fluctuations, and so theobjectives for a central bank in the context of a long-run strategy should thus not onlyinclude minimizing inflation fluctuations, but should also include minimizing outputfluctuations.Objective functions with these characteristics have now become standard inthe monetary economics literature which focuses on the conduct of monetary policy(e.g., see the papers in Taylor, 1999)7.TheMostSerious EconomicDownturns areAssociated withFinancialInstability.A reading of U.S. monetary history (Friedman and Schwartz, 1963,Bernanke, 1983,and Mishkin,1991)indicates that the most serious economic contractionsin U.S.history,including the Great Depression,have all been associated with financialinstability. Indeed this literature suggests that financial instability is a key reason forthe depth of these economic contractions.The recent financial crises and depressions inMexico and East Asia also support this view (Mishkin,1996,1999a and Corsetti, Pesenti,and Roubini,1998).Preventingfinancial instability is therefore crucial to promotingahealthy economy and reducing output fluctuations, an important objective for centralbanks, as wehaveseenabove.II.ImplicationsfortheRoleofaCentralBankArmed with these seven guiding principles, we can now go on to look whatinstitutional features a central bank should have in conducting its operations.We derivethe following implications/criteria for the role of a central bank: 1) Price stabilityshould be the overriding, long-run goal of monetary policy; 2) An explicit nominalanchor should be adopted; 3) A central bank should be goal dependent; 4) A central bankshouldbeinstrument independent; 5)Acentralbankshouldbeaccountable; 6)Acentral5

5 6. Monetary Policy Should be Concerned with Output as Well as Price Fluctuations. Price stability is a means to an end, a healthy economy, and should not be treated as an end in itself. Thus, central bankers should not be obsessed with inflation control, and become what Mervyn King (1997) has characterized as "inflation nutters". Clearly the public cares about output as well as inflation fluctuations, and so the objectives for a central bank in the context of a long-run strategy should thus not only include minimizing inflation fluctuations, but should also include minimizing output fluctuations. Objective functions with these characteristics have now become standard in the monetary economics literature which focuses on the conduct of monetary policy (e.g., see the papers in Taylor, 1999) 7. The Most Serious Economic Downturns are Associated with Financial Instability. A reading of U.S. monetary history (Friedman and Schwartz, 1963, Bernanke, 1983, and Mishkin, 1991) indicates that the most serious economic contractions in U.S. history, including the Great Depression, have all been associated with financial instability. Indeed this literature suggests that financial instability is a key reason for the depth of these economic contractions. The recent financial crises and depressions in Mexico and East Asia also support this view (Mishkin, 1996, 1999a and Corsetti, Pesenti, and Roubini, 1998). Preventing financial instability is therefore crucial to promoting a healthy economy and reducing output fluctuations, an important objective for central banks, as we have seen above. III. Implications for the Role of a Central Bank Armed with these seven guiding principles, we can now go on to look what institutional features a central bank should have in conducting its operations. We derive the following implications/criteria for the role of a central bank: 1) Price stability should be the overriding, long-run goal of monetary policy; 2) An explicit nominal anchor should be adopted; 3) A central bank should be goal dependent; 4) A central bank should be instrument independent; 5) A central bank should be accountable; 6) A central

bank should stress transparency and communication; 7) A central bank should also havethegoal offinancial stability.Price Stability Should be the Overriding, Long-Run Goal of MonetaryPolicyTogether, thefirst three principles for monetary policy outlined above suggestthat the overriding, long-run goal of monetary policy should be price stability. A goalof price stability immediatelyfollows from the benefits of low and stable inflationwhich promote higher economic output.Furthermore, an institutional commitment toprice stability is one way to make time-inconsistency of monetary policy less likely.Aninstitutional commitment to the price stability goal provides a counter to time-inconsistency because it makes it clear that the central bank must focus on the long-runand thus resist the temptation to pursue short-run expansionary policies that areinconsistentwiththelong-run,price stabilitygoal.The third principle that fiscal policy should be aligned with monetary policyprovides another reason why price stability should be the overriding, long-run goal ofmonetary policy.As McCallum (1990) has pointed out,"unpleasant monetaristarithmetic"onlyarises ifthefiscal authorities arethe first mover.In otherwords if thefiscal authorities are the dominant player and so can movefirst, thus setting fiscal policyexogenouslyknowing thatthe monetary authorities will beforced to accommodatetheir policies to maintain the long-run government budget constraint, then fiscal policywill determine the inflation rate. Indeed, this is the essence of the fiscal theory of theprice level.On the other hand, as McCallum (1990) points out, if the monetaryauthorities are the dominant player and move first, then it will be fiscal policy that willaccommodate in order to satisfy the long-run government budget constraint, andmonetarypolicy will determinethe inflation rate.An institutional commitment to pricestability as the overriding, long-run goal, is just one way to ensure that monetary policymoves first and dominates,forcingfiscal policyto align with monetarypolicy.The sixth guiding principle that output fluctuations should also be a concern ofmonetary policy suggests that a fanatic pursuit of pursuit of price stability could beproblematic because policymakers should see not only price fluctuations but also outputfluctuations as undesirable. This is why the price stability goal should be seen asoverriding in the long-run, but not in the short-run. As Lars Svensson (1999) has put it,6

6 bank should stress transparency and communication; 7) A central bank should also have the goal of financial stability. Price Stability Should be the Overriding, Long-Run Goal of Monetary Policy Together, the first three principles for monetary policy outlined above suggest that the overriding, long-run goal of monetary policy should be price stability. A goal of price stability immediately follows from the benefits of low and stable inflation which promote higher economic output. Furthermore, an institutional commitment to price stability is one way to make time-inconsistency of monetary policy less likely. An institutional commitment to the price stability goal provides a counter to time￾inconsistency because it makes it clear that the central bank must focus on the long-run and thus resist the temptation to pursue short-run expansionary policies that are inconsistent with the long-run, price stability goal. The third principle that fiscal policy should be aligned with monetary policy provides another reason why price stability should be the overriding, long-run goal of monetary policy. As McCallum (1990) has pointed out, "unpleasant monetarist arithmetic" only arises if the fiscal authorities are the first mover. In other words if the fiscal authorities are the dominant player and so can move first, thus setting fiscal policy exogenously knowing that the monetary authorities will be forced to accommodate their policies to maintain the long-run government budget constraint, then fiscal policy will determine the inflation rate. Indeed, this is the essence of the fiscal theory of the price level. On the other hand, as McCallum (1990) points out, if the monetary authorities are the dominant player and move first, then it will be fiscal policy that will accommodate in order to satisfy the long-run government budget constraint, and monetary policy will determine the inflation rate. An institutional commitment to price stability as the overriding, long-run goal, is just one way to ensure that monetary policy moves first and dominates, forcing fiscal policy to align with monetary policy. The sixth guiding principle that output fluctuations should also be a concern of monetary policy suggests that a fanatic pursuit of pursuit of price stability could be problematic because policymakers should see not only price fluctuations but also output fluctuations as undesirable. This is why the price stability goal should be seen as overriding in the long-run, but not in the short-run. As Lars Svensson (1999) has put it

central banks should pursue what he calls "flexible inflation targeting", in which thespeed at which a central bank tries to get to price stability reflects their concerns aboutoutput fluctuations.Themore heavily a central bank cares aboutoutput fluctuations,themore time it should take to return to price stability when it is not already there.However, because a "flexible inflation targeter"always sets a long-term price stabilitygoal for inflation, the fact that a central bank cares about output fluctuations is entirelyconsistent with price stability as the long-run, overriding goal.AnExplicit Nominal Anchor Should beAdoptedAlthough an institutional commitment to price stability helps solve time-inconsistency and fiscal alignment problems, it does not go far enough because pricestability is not a clearly defined concept. Typical definitions of price stability have manyelements in common with the commonly used legal definition of pornography in theUnited States --you know it when you see it.Constraints on fiscal policy anddiscretionary monetary policy to avoid inflation might thus end up being quite weakbecause not everyone will agree on what price stability means in practice, providingboth monetary policymakers and politicians a loophole to avoid making toughdecisions tokeep inflation under control. A solution to this problem which supports thefirst three guiding principles is to adopt an explicit nominal anchor that ties downexactly whatthe commitmenttoprice stabilitymeans.There are several forms that an explicit nominal anchor can take.One is acommitment to a fixed exchange rate. For example, in 1991, Argentina established acurrency board that required the central bank to exchange U.S. dollars for new pesos at afixed exchange rate of one to one.A second nominal anchor is for the central bank tohave a money-growth target, as was the case in Germany. A third nominal anchor is forthere to be an explicit numerical inflation goal as in inflation targeting countries such asNew Zealand, Canada and the United Kingdom, Australia and Brazil, among others.Allthese forms of explicit nominal anchors can help reduce the time-inconsistency problem,as the success of countries using them in lowering and controlling inflationdemonstrates (Mishkin, 1999b) These nominal anchors also help restrain fiscal policyand are also seen as an important benefit of inflation targeting in countries such as NewZealand and Canada (Mishkin and Posen, 1997, and Bernanke, Laubach, Mishkin andPosen, 1999).7

7 central banks should pursue what he calls "flexible inflation targeting", in which the speed at which a central bank tries to get to price stability reflects their concerns about output fluctuations. The more heavily a central bank cares about output fluctuations, the more time it should take to return to price stability when it is not already there. However, because a "flexible inflation targeter" always sets a long-term price stability goal for inflation, the fact that a central bank cares about output fluctuations is entirely consistent with price stability as the long-run, overriding goal. An Explicit Nominal Anchor Should be Adopted Although an institutional commitment to price stability helps solve time￾inconsistency and fiscal alignment problems, it does not go far enough because price stability is not a clearly defined concept. Typical definitions of price stability have many elements in common with the commonly used legal definition of pornography in the United States - you know it when you see it. Constraints on fiscal policy and discretionary monetary policy to avoid inflation might thus end up being quite weak because not everyone will agree on what price stability means in practice, providing both monetary policymakers and politicians a loophole to avoid making tough decisions to keep inflation under control. A solution to this problem which supports the first three guiding principles is to adopt an explicit nominal anchor that ties down exactly what the commitment to price stability means. There are several forms that an explicit nominal anchor can take. One is a commitment to a fixed exchange rate. For example, in 1991, Argentina established a currency board that required the central bank to exchange U.S. dollars for new pesos at a fixed exchange rate of one to one. A second nominal anchor is for the central bank to have a money-growth target, as was the case in Germany. A third nominal anchor is for there to be an explicit numerical inflation goal as in inflation targeting countries such as New Zealand, Canada and the United Kingdom, Australia and Brazil, among others. All these forms of explicit nominal anchors can help reduce the time-inconsistency problem, as the success of countries using them in lowering and controlling inflation demonstrates (Mishkin, 1999b) These nominal anchors also help restrain fiscal policy and are also seen as an important benefit of inflation targeting in countries such as New Zealand and Canada (Mishkin and Posen, 1997, and Bernanke, Laubach, Mishkin and Posen, 1999)

One criticism of adopting an explicit nominal anchor such as an inflation target isthat it will necessarily result in too little emphasis on reducing output fluctuations,which is inconsistent with the guiding principal that monetary policy should beconcerned with output as well as pricefluctuations.However, this view is mistaken.Inflation targeting, as it has actually been practiced (Mishkin and Posen, 1997, andBernanke,Laubach,Mishkin and Posen,1999),has been quiteflexible andhasnotled tolarger output fluctuations. Indeed, adoption of an inflation target can actually make iteasier for central banks to deal with negative shocks to the aggregate economy. Becausea decline in aggregate demand also leads to lower-than-expected inflation, a centralbank is able to respond with a monetary easing,without causing the public to questionit anti-inflationary resolve.Furthermore, inflation targeting can make it less likely thatdeflation, a fall in the price level, would occur. There are particularly valid reasons forfearing deflation in today's world, includingthe possibility that it might promotefinancial instability and precipitate a severe economic contraction.Indeed, deflation hasbeen associated with deep recessions or even depressions, as in the 1930s, and the recentdeflation in Japan has been one factor that has weakened the financial system and theeconomy. Targeting inflation rates of above zero, as all inflation targeters have done,makes periods of deflation less likely.The evidence on inflation expectations fromsurveys and interest rate levels suggest that maintaining a target for inflation abovezero (but not too far above) for an extended period does not lead to instability ininflation expectations or to a decline in the central bank's credibility.CentralBanksShouldbeGoalDependentAlthough there is a strong rationale for the price stability goal and an explicitnominal anchor, who should make the institutional commitment? Should the centralbank independently announce its commitment to the price stability goal or would it bebetter to have this commitment be mandated by the government?Here the distinction between goal independence and instrument independencemade by Debelle and Fischer (1994) and Fischer (1994) is quite useful.Goalindependence is the ability of the central bank to set its own goals for monetary policy,while instrument independence is the ability of the central bank to independently set theinstruments of monetary policy to achieve the goals. The fifth guiding principle, sobasic to democracy, that the public must be able to exercise control over government8

8 One criticism of adopting an explicit nominal anchor such as an inflation target is that it will necessarily result in too little emphasis on reducing output fluctuations, which is inconsistent with the guiding principal that monetary policy should be concerned with output as well as price fluctuations. However, this view is mistaken. Inflation targeting, as it has actually been practiced (Mishkin and Posen, 1997, and Bernanke, Laubach, Mishkin and Posen, 1999), has been quite flexible and has not led to larger output fluctuations. Indeed, adoption of an inflation target can actually make it easier for central banks to deal with negative shocks to the aggregate economy. Because a decline in aggregate demand also leads to lower-than-expected inflation, a central bank is able to respond with a monetary easing, without causing the public to question it anti-inflationary resolve. Furthermore, inflation targeting can make it less likely that deflation, a fall in the price level, would occur. There are particularly valid reasons for fearing deflation in today's world, including the possibility that it might promote financial instability and precipitate a severe economic contraction. Indeed, deflation has been associated with deep recessions or even depressions, as in the 1930s, and the recent deflation in Japan has been one factor that has weakened the financial system and the economy. Targeting inflation rates of above zero, as all inflation targeters have done, makes periods of deflation less likely. The evidence on inflation expectations from surveys and interest rate levels suggest that maintaining a target for inflation above zero (but not too far above) for an extended period does not lead to instability in inflation expectations or to a decline in the central bank's credibility. Central Banks Should be Goal Dependent Although there is a strong rationale for the price stability goal and an explicit nominal anchor, who should make the institutional commitment? Should the central bank independently announce its commitment to the price stability goal or would it be better to have this commitment be mandated by the government? Here the distinction between goal independence and instrument independence made by Debelle and Fischer (1994) and Fischer (1994) is quite useful. Goal independence is the ability of the central bank to set its own goals for monetary policy, while instrument independence is the ability of the central bank to independently set the instruments of monetary policy to achieve the goals. The fifth guiding principle, so basic to democracy, that the public must be able to exercise control over government

actions and so policymakers must be accountable, strongly suggests that the goals ofmonetary policy should be set by the elected government. In other words, a centralbank should not be goal independent.The corollary of this view is that the institutionalcommitment to price stability should come from the government in the form of anexplicit, legislated mandate for the central bank to pursue price stability as itsoverriding,long-rungoal.Not only is a legislated mandate and goal dependence of the central bankconsistent with basic principles of democracy, but it has the further advantage that it isconsistent with the second and third guiding principles -- it makes time-inconsistencyless likely,while making alignment of fiscal policy with monetary policy more likelyAs we discussed above, the source of thetime-inconsistency problem is more likely tobe embedded in the political process than it is in the central bank. Once politicianscommit to the price stability goal by passing central bank legislation with a pricestability mandate, it becomes harderfor them to put pressure on the central bank topursue short-run expansionary policies that are inconsistent with the price stability goalFurthermore, a government commitment to price stability is also a commitment tomaking monetary policy dominant over fiscal policy, ensuring a better alignment offiscal policywithmonetarypolicy.An alternative way to solve time-inconsistency problems has been suggested byRogoff (1985): grant both goal and instrument independence to a central bank and thenappoint conservative central bankers to run it who put more weight on controllinginflation relative to output than does the general public.The result will be lowinflation, but at the cost of higher output variability than the public desires.There aretwoproblems withthis solution.First,having"conservative"central bankers imposedifferent preferences than the public on the conduct of monetary policy is inherentlyundemocratic.Basicdemocraticprinciples indicate thatthepreferences of policymakingshould be aligned with those of the society at large. Second, in the long run a centralbank cannot operate without the support of the public. If the central bank is seen to bepursuing goals that are not what the public wants, support for central bankindependence is likely to erode.Thus appointment of "conservative" central bankersmay not be stable in the long run and will not provide a permanent solution to the time-inconsistencyproblem.The same principles that suggest that the central bank should be goal dependent,9

9 actions and so policymakers must be accountable, strongly suggests that the goals of monetary policy should be set by the elected government. In other words, a central bank should not be goal independent. The corollary of this view is that the institutional commitment to price stability should come from the government in the form of an explicit, legislated mandate for the central bank to pursue price stability as its overriding, long-run goal. Not only is a legislated mandate and goal dependence of the central bank consistent with basic principles of democracy, but it has the further advantage that it is consistent with the second and third guiding principles - it makes time-inconsistency less likely, while making alignment of fiscal policy with monetary policy more likely. As we discussed above, the source of the time-inconsistency problem is more likely to be embedded in the political process than it is in the central bank. Once politicians commit to the price stability goal by passing central bank legislation with a price stability mandate, it becomes harder for them to put pressure on the central bank to pursue short-run expansionary policies that are inconsistent with the price stability goal. Furthermore, a government commitment to price stability is also a commitment to making monetary policy dominant over fiscal policy, ensuring a better alignment of fiscal policy with monetary policy. An alternative way to solve time-inconsistency problems has been suggested by Rogoff (1985): grant both goal and instrument independence to a central bank and then appoint conservative central bankers to run it who put more weight on controlling inflation relative to output than does the general public. The result will be low inflation, but at the cost of higher output variability than the public desires. There are two problems with this solution. First, having "conservative" central bankers impose different preferences than the public on the conduct of monetary policy is inherently undemocratic. Basic democratic principles indicate that the preferences of policymaking should be aligned with those of the society at large. Second, in the long run a central bank cannot operate without the support of the public. If the central bank is seen to be pursuing goals that are not what the public wants, support for central bank independence is likely to erode. Thus appointment of "conservative" central bankers may not be stable in the long run and will not provide a permanent solution to the time￾inconsistency problem. The same principles that suggest that the central bank should be goal dependent