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Expectations, Credibility,
and Time-Consistent
Monetary Policy
by Peter N. Ireland
FEDERAL RESERVE BANK
OF CLEVELAND
Working Paper 9812
EXPECTATIONS, CREDIBILITY, AND TIME-CONSISTENT
MONETARY POLICY
by Peter N. Ireland
The author thanks seminar participants at the Federal Reserve Bank of Cleveland, New York University, the
University of Iowa, the University of Quebec at Montreal, the Wharton School of the University of
Pennsylvania, and Yale University for helpful comments and suggestions.
Working papers of the Federal Reserve Bank of Cleveland are preliminary materials circulated to stimulate
discussion and critical comment on research in progress. They may not have been subject to the formal
editorial review accorded official Federal Reserve Bank of Cleveland publications.
The views stated herein are those of the authors and are not necessarily those of the Federal Reserve Bank
of Cleveland or of the Board of Governors of the Federal Reserve System.
Working papers are now available electronically through the Cleveland Fed's home page on the World
Wide Web: http://www.clev.frb.org.
September 1998
Expectations, Credibility, and Time-Consistent Monetary Policy
by Peter N. Ireland
This paper addressses the problem of multiple equilibria in a model of time-consistent monetary policy. It
suggests that this problem originates in the assumption that agents have rational expectations and proposes
several alternative restrictions on expectations that allow the monetary authority to build credibility for a
disinflationary policy by demonstrating that it will stick to that policy even if it imposes short-run costs on
the economy. Starting with these restrictions, the paper derives conditions that guarantee the uniqueness of
the model’s steady state; monetary policy in this unique steady state involves the constant deflation
advocated by Milton Friedman.
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Fkdul/ Y1Y1 dqg Sdwulfn M1 Nhkrh1 Vxvwdlqdeoh Sodqv1 Mrxuqdo ri Srolwlfdo
Hfrqrp| <; +Dxjxvw 4<<3,= :;60;351
Fkr/ Lq0Nrr dqg Dnlklnr Pdwvxl1 Lqgxfwlrq dqg wkh Udpvh| Srolf|1 Mrxuqdo
ri Hfrqrplf G|qdplfv dqg Frqwuro 4< +Mxo|0Vhswhpehu 4<<8,= 4446044731
Iulhgpdq/ Plowrq1 Wkh Rswlpxp Txdqwlw| ri Prqh|1 Lq Wkh Rswlpxp Txdq0
wlw| ri Prqh| dqg Rwkhu Hvvd|v1 Fklfdjr= Doglqh Sxeolvklqj Frpsdq|/
4<9<1
Ixfkv/ Jhudug1 Lv Huuru Ohduqlqj Ehkdylrxu Vwdelol}lqjB Mrxuqdo ri Hfrqrplf
Wkhru| 53 +Mxqh 4<:<,= 633064:1
Ixfkv/ Jhudug dqg Jx| Odurtxh1 G|qdplfv ri Whpsrudu| Htxloleuld dqg H{0
shfwdwlrqv1 Hfrqrphwulfd 77 +Qryhpehu 4<:9,= 448:044:;1
Judqgprqw/ Mhdq0Plfkho dqg Jx| Odurtxh1 Vwdelolw| ri F|fohv dqg H{shfwd0
wlrqv1 Mrxuqdo ri Hfrqrplf Wkhru| 73 +Ghfhpehu 4<;9,= 46;04841
6:
Luhodqg/ Shwhu Q1 Vxvwdlqdeoh Prqhwdu| Srolflhv1 Pdqxvfulsw1 Qhz Euxqvzlfn=
Uxwjhuv Xqlyhuvlw|/ Ghsduwphqw ri Hfrqrplfv/ Qryhpehu 4<<91
N|godqg/ Ilqq H1 dqg Hgzdug F1 Suhvfrww1 Uxohv Udwkhu wkdq Glvfuhwlrq= Wkh
Lqfrqvlvwhqf| ri Rswlpdo Sodqv1 Mrxuqdo ri Srolwlfdo Hfrqrp| ;8 +Mxqh
4<::,= 7:607<41
Oxfdv/ Urehuw H1/ Mu1 Htxloleulxp lq d Sxuh Fxuuhqf| Hfrqrp|1 Hfrqrplf
Lqtxlu| 4; +Dsulo 4<;3,= 53605531
Pdufhw/ Doehuw dqg Wkrpdv M1 Vdujhqw1 Frqyhujhqfh ri Ohdvw Vtxduhv Ohduq0
lqj Phfkdqlvpv lq Vhoi0Uhihuhqwldo Olqhdu Vwrfkdvwlf Prghov1 Mrxuqdo ri
Hfrqrplf Wkhru| 7; +Dxjxvw 4<;<,= 66:069;1
PfFdooxp/ Ehqqhww W1 Wzr Idoodflhv Frqfhuqlqj Fhqwudo0Edqn Lqghshqghqfh1
Dphulfdq Hfrqrplf Uhylhz ;8 +Pd| 4<<8,= 53:05441
Urjr / Nhqqhwk1 Uhsxwdwlrq/ Frruglqdwlrq/ dqg Prqhwdu| Srolf|1 Lq Urehuw
M1 Eduur/ hg1 Prghuq Exvlqhvv F|foh Wkhru|1 Fdpeulgjh= Kduydug Xqlyhu0
vlw| Suhvv/ 4<;<1
Uxelqvwhlq/ Dulho1 Ilqlwh Dxwrpdwd Sod| wkh Uhshdwhg Sulvrqhu*v Glohppd1
Mrxuqdo ri Hfrqrplf Wkhru| 6< +Mxqh 4<;9,= ;60<91
6;
Vdujhqw/ Wkrpdv M1 Erxqghg Udwlrqdolw| lq Pdfurhfrqrplfv1 R{irug= Foduhqgrq
Suhvv/ 4<<61
Vwrnh|/ Qdqf| O1 Fuhgleoh Sxeolf Srolf|1 Mrxuqdo ri Hfrqrplf G|qdplfv dqg
Frqwuro 48 +Rfwrehu 4<<4,= 95:09891
Wd|oru/ Mrkq E1 Hvwdeolvklqj Fuhglelolw|= D Udwlrqdo H{shfwdwlrqv Ylhzsrlqw1
Dphulfdq Hfrqrplf Uhylhz :5 +Pd| 4<;5,= ;40;81
Wloopdqq/ Jhruj1 Vwdelolw| lq d Vlpsoh Sxuh Frqvxpswlrq Ordq Prgho1 Mrxu0
qdo ri Hfrqrplf Wkhru| 63 +Dxjxvw 4<;6,= 648065<1
6<
@FedFRASER