What If Monetary Policymakers Lack Credibility?

Trevor Chow sent me the following questions, as a follow up to my recent post:

I was wondering what your thoughts are regarding the following:

1. I agree that the thought experiment shows monetary policy can set nominal aggregates as high as they would like. But I’m not entirely sure this solves the machete-scalpel problem.

2. What I mean is the following. Suppose we start in a world where we’re on some nGDP growth path. Suddenly, there’s a recession (V falls/k rises) and expected nGDP falls. The central bank tells everyone about this helicopter thought experiment and persuades them that it can credibly maintain the nGDP growth path. Consequently, it needs to do very little actual money creation in order to keep nGDP futures on the nGDP growth path. And so expected nGDP doesn’t actually fall. This is basically what you were saying.

3. However, suppose instead that for some reason it screws up. And for some reason, people no longer believe that the thought experiment is enough i.e. they believe in the machete-scalpel problem. Perhaps this is because they mess up for a period of time or because everyone misdiagnoses what tight and loose policy are. Regardless, it is no longer credible. Then it can’t just say it wants an nGDP path and hope that people will respond accordingly, and in fact might have to do a lot just to get close.

4. This may be particularly difficult because people’s belief in a central bank depends on whether they think other people find the central bank to be credible. And in that sense, it would seem likely that while what you’re saying is true most of the time, it is possible to get stuck in bad equilibria where you need a lot more than the usual show of force to even begin regaining control of the scalpel?

5. What I’m trying to say, albeit somewhat poorly, is that the machete-scalpel problem seems to be true if everyone believes it to be true, and to be false if everyone believes it to be false.

I’m going to disagree with this:

This may be particularly difficult because people’s belief in a central bank depends on whether they think other people find the central bank to be credible.

In my view, people tend to doubt central bank commitments mostly when central banks are not in fact committed to doing whatever it takes. Yes, you can imagine a hypothetical case where a central bank was committed to do whatever it takes to boost inflation, but the public for some reason still did not believe the central bank. But I suspect that that’s pretty rare. It is most likely to happen in a case where a central bank had previously made a commitment that was not sincere, reneged on its promise, and then subsequently made a commitment that was sincere, but not credible.

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