Monetary policy games and the role of private information

Consider the following scenario: monetary aggregates surge ahead of expected or targeted rates; the Fed claims that it is accommodating a perceived increase in money demand in order to stabilize the price level; the private sector (or the administration, or Congress) counters that the Fed is running an inflationary policy to expand employment; a period of credibility building ensues, which may focus upon the personalities of policymakers, targeting procedures, or even proposals for legislative reform. A key element in this scenario is that the private sector cannot verify the Fed's claim; the Fed's forecast of money demand is private information. A plausible explanation for such a scenario is that the Fed is involved in a noncooperative game with certain agents in the private sector, or with some other branch of government. Why else, for example, would the Fed seek to constrain its own behavior, with say a targeting procedure, unless it thought that this would bring a resolution to a credibility problem resulting from a noncooperative game. ' And why does the Fed have a "credibility" problem, as opposed to an "information" problem; that is, why are its announcements not accepted at face value? A game suggested by Finn Kydland and Edward Prescott (1977) has received considerable attention.2 In this game, wage setters have to specify the nominal wage in a labor contract before the Fed sets the money supply. The Fed wants a higher level of employment than the wage setters, but it is also inflation conscious. The wage setters know that the Fed will be tempted to inflate away some of their real wage, to achieve a higher level of employment, so they purposely set the wage high. The Fed weights its employment and inflation objectives, and only finds it optimal to inflate the real wage down to the level wanted by the wage setters. The noncooperative solution has an inefficient inflation bias, simply because the Fed has no credible way of precommitting itself to a noninflationary policy. Adding a stabilization role for monetary policy, and private information, the Kydland-Prescott game can be used to model the scenario outlined above. There are a variety of ways in which the noncooperative solution described above might be improved upon. Congress could legislate institutional reforms. It could legislate a monetary policy rule directly, or it could constrain the behavior of the players by changing the rules of the game; wage-price guidelines and legislated targeting procedures are examples of the later. Earl Thompson (1981) and Kenneth Rogoff suggest changing the incentive structure for Fed policymakers, or simply choosing a policymaker with " perverse" preferences. And Robert Barro and David Gordon (1983a) suggest that the players themselves may have already found a resolution to the problem in a reputation-building mechanism. An efficient resolution of the credibility problem must leave the Fed with the latitude to perform its stabilization role. Rogoff and *Georgetown University, Washington, D.C. 20057. I thank R. Cooper, J. Friedman, E. Green, D. Henderson, B. McCallum, K. Rogoff, J. Taylor, and an anonymous referee for helpful comments; however, the views presented here are my own. They are not necessarily shared by the Federal Reserve Board or any other member of its staff. ' Targeting money or interest rates is not likely to be efficient in terms of meeting final targets; see, for example, my 1977 article. This observation is the principal theme of Kenneth Rogoff (forthcoming). 2See Robert Barro and David Gordon (1983a,b), John Taylor (1983), S. Green (1983), Rogoff, David Baccus and John Driffill (1985), and more generally, W. Lee (1981). Edmund Phelps (1967) had many of the elements of this game.