Reserve bank autonomy and the credibility of monetary policy: A game‐theoretic approach

Abstract

The Reserve Bank of New Zealand Act 1989 introduces at least two important changes to the institutional framework of monetary policy: it removes the Minister of Finance from involvement in day to day operations of monetary policy and it amends the statutory objectives of monetary policy to focus exclusively on price stability. The desire to ensure time‐consistency, and hence credibility, of monetary policy has been one of the driving forces behind the implementation of this Act. A simple model is used to analyse within a game‐theoretic framework, some complications that could arise if the Government's true objective function differs from that which guides the Reserve Bank. In a conflict between the objectives of monetary and fiscal authorities, it is shown that fiscal policy objectives may reduce the prospect of price stability. This potential threat to price stability from conflicting fiscal authority objectives means that a non‐preferred monetary response may have to be chosen so as to minimise the adverse consequences of fiscal intervention. Thus, a conflict of objectives has the prospect of undermining the ability of the Bank to achieve its statutory objective and so undermine the credibility of monetary policy.

Notes

The original version of this paper was prepared while Bob Buckle was a Visiting Fellow in the Department of Economics, Research School of Social Sciences, Australian National University. Subsequent venions of the paper were presented to seminars at the Research School of Pacific Studies, Australian National University, at the University of Toronto, Queen's University, Canada and to a conference of the Canadian Economic Association. The authors are grateful to participants at those seminars as well as to Geoffrey Brennan, Steve Dowrick, the editor and three anonymous referees for constructive comments and suggestions.