In this paper we, first, by explicitly taking account of the private sector's influence and pressure on the monetary authorities, provide a more plausible representation of the motivations of the two main players. We then incorporate persistence into the model and show that the optimal policy of the authorities will be state dependent. Finally and most importantly, we highlight an inconsistency between two strands in the literature of monetary analysis, namely the long lags of monetary policy and the time inconsistency. Such a lag of monetary policy means that the policy will be transparently observed before it affects the economy, consequently the Central Bank cannot fool anybody who has not already bound herself into a contract longer than that lag. Even if such contracts are pervasive, the inflationary bias arising from time inconsistency must be much smaller than that previously assessed.
Publication Date
Financial Markets Group Discussion Papers DP 222
