Pursuit of Truthiness

my gut tells me I know economics

The Fed Can Commit

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Anna seems to trust Ben's commitment

I have heard otherwise-intelligent people insist that the Federal Reserve is incapable of making believable commitments to take certain actions in the future.  For instance, Angus keeps saying things like

“Please repeat after me:

THE FED HAS NO MECHANISM TO BIND ITSELF TO LIVE UP TO ANY ARBITRARY PROMISES IT MAY MAKE TODAY ABOUT THE FUTURE!!!

Promises to act against one’s preferences in the future that are made without any commitment mechanism are simply cheap talk and are extremely unlikely to shape agent’s expectations or actions.”

It is obviously wrong to say that the Fed has no commitment mechanism.  The Fed makes believable commitments every day.  It does not need to resort to Schelling-style special tricks like having its employees make contracts with 3rd-parties to lose lots of money if the inflation target is missed (though of course these tricks are available and potentially useful).  The real commitment mechanism is that your reputation is itself a valuable thing, and the Fed’s leaders know this and have less-than-infinite discount rates.  Ben Bernanke has carefully developed a reputation for keeping his word; he is not going to throw this durable good away in 2012, because he will still find it useful in 2013, and he values his 2013-utility a significant positive amount.  Because Bernanke knows the importance of the expectations channel, he knows his reputation is more important than just about any one-time action.  Ben will not sell his birthright for a mess of pottage.

We don’t even need to delve into the complexities of monetary policy to establish the obvious truth that the Fed can make commitments.  Just consider the fact that thousands of Fed employees feel almost certain that the Fed will give them their next paycheck as promised.  Surely the Fed would benefit in the short term by not paying them; it could get them to keep working for a few weeks at least by insisting there was some technical problem with the payroll system.  Why doesn’t the Fed try this?  Because the leaders of the Fed know that their reputation for doing what they say [eg paying people, even if they promised too high a salary] is far more valuable than any short-term savings.  Their employees know this too, making it much easier for the Fed to manage their own labor market; for instance, no one is demanding payment up front, because they trust they will be paid later.  Similarly, the FOMC announces their meeting dates months ahead of time.  Somehow they always manage to meet when they said they would, even if everyone attending realizes at the last minute it is not a great time; they value their reputation more than a one-time inconvenience.  That’s some magical stuff right there people!

Odysseus binds himself to the mast

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Written by James Bailey

October 17, 2011 at 3:47 pm

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