Quiz 18: Rules for Monetary Policy
The expectation trap refers to the high inflationary stage of economy as a result of people's expectations about monetary policy. If people think that Fed will cut its fund rate then there will be possibility of higher inflation rate as a result of it. And due to this high inflation rate people will expect a long term tight monetary policy with higher interest rate. And it will lead to a slow growing economy in the long run. Hence in order to cope with this expectation related issues at present Fed will cut its fund rate and this will lead a higher level of inflation rate. This phenomenon is precisely termed as expectation trap. If people thought that Fed was going to raise inflation rate from 2 % to 3% then they will expect in future Fed will follow a tight monetary policy with a higher interest rate. And hence correspondingly the economy will enter into a slow growth path in future. Hence to combat this gloomy expectation situations Fed has to react and then Fed would cut its fund rate and inflation will rise.
Time inconsistency refers to the issue of changing policy over time by the Fed. Usually one policy apparently seems to be an optimal policy for the Fed in one time afterward Fed usually deviate from that policy. For example suppose if Fed announces that it would like to maintain a constant price level. Hence worker and owners may believe Fed and would agree to maintain a negotiated wage level. But in that case if Fed conduct monetary easing then it the monetary value of the output would rise and real wage would fall. And more workers can be hired and output growth may increase. So this is time inconsistency. The problem of this can be solved if Fed remains its stance intact about monetary policy. It implies that if Fed announces a constant level of price and it follows it over time then price level would not be affected by monetary policy and the problem of time inconsistency can be addressed.
There are largely two ways to ensure credibility of Fed's policy such that it does not become time inconsistent. One way to make it is that if Fed put higher importance about maintaining low inflation rather than focusing on output growth. Largely Fed under politician's influence before election usually ease monetary policy to boost output growth. Hence one way to maintain Fed's credibility is to maintain its independence from politician's influence. Empirically it has been found that the countries where Fed enjoys more independence use to experience lesser time inconsistency problem. And those countries experience a lower inflation level. Also another way to maintain credibility of Fed is to choose very conservative people as governors of Fed such that it does not follow too much discretion in formulating monetary policy.