Economic reforms and the indirect role of monetary policy

Abstract

Due to pressure from some lobbies, the government is unwilling to perform structural reforms. The probability of its re-election depends, however, on a positive business cycle. The central bank may create surprise deflation even though it maximizes the public's utility function and even if it faces a rational market. This may explain why the European Central Bank (ECB), but not the US Federal Reserve (FED), is found to be unaffected by the inflation bias.

Keywords:

• political business cycles
• time inconsistency of monetary policy

JEL Classification:

• E32
• E58

Notes

¹ The Security Market Programme (SMP) is defined as ‘Interventions by the Eurosystem in public and private debt securities markets …’, see the European Central Bank's (ECB's) website.

² The ECB wrote an official letter to the Italian government in the summer of 2011 indicating urgent policies aimed at increasing the potential output. Furthermore, in the press conference on 3 November 2011, ECB President Draghi hinted that the purchase of (Italian) government bonds within the SMP is conditional on the implementation of the indicated reforms.

³ If the government's utility function includes the welfare function, the government should also consider the decrease in this function once the central bank creates surprise deflation.

⁴ This FOC holds in election periods (t, t + 2, …). In order to find the FOC in nonelection periods, set PG_t  = 1 in Equation 6.(6)

⁵ Around a null value of the output gap.

⁶ Provided that .

⁷ Provided that .

⁸ Absent in the standard time-inconsistency models.