fiscal economics policy

7/27/2019 Fiscal Economics Policy

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I NTRODUCTIONFiscal policy, taking the scope ofbudgetary policy, refer togovernment policy that attempts to influence the direction of theeconomy through changes in government taxes, or through somespending (fiscal allowances).

Fiscal policy can be contrasted with the other main type ofmacroeconomic policy, monetary policy, which attempts tostabilize the economy by controlling interest rates and thesupply ofmoney. The two main instruments of fiscal policy aregovernment spending and taxation. Changes in the level andcomposition of taxation and government spending can impact on

the following variables in the economy:

Aggregate demand and the level of economic activity The pattern of resource allocation

The distribution of income.

MEANING

Fiscal policy refers to the overall effect of the budget outcomeon economic activity. The three possible stance of fiscal policyare neutral, expansionary and contractionary:

1.A neutral stance of fiscal policy implies a balanced budget

where G = T (Government spending = Tax revenue).Government spending is fully funded by tax revenue and overallthe budget outcome has a neutral effect on the level of economicactivity.

2.An expansionary stance of fiscal policy involves a net increasein government spending (G > T) through a rise in governmentspending or a fall in taxation revenue or a combination of the

two. This will lead to a larger budget deficit or a smaller budgetsurplus than the government previously had, or a deficit if the
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government previously had a balanced budget. Expansionaryfiscal policy is usually associated with a budget deficit.

3. Contractionary fiscal policy (G < T) occurs when net

government spending is reduced either through higher taxationrevenue or reduced government spending or a combination ofthe two. This would lead to a lower budget deficit or a largersurplus than the government previously had, or a surplus if thegovernment previously had a balanced budget. Contractionaryfiscal policy is usually associated with a surplus.

Methods of funding

Governments spend money on a wide variety of things, from themilitary and police to services like education and healthcare, aswell as transfer payments such as welfare benefits.

This expenditure can be funded in a number of different ways:

Taxation Seignorage, the benefit from printing money

Borrowing money from the population, resulting in a fiscaldeficit.

Consumption of fiscal reserves.

Sale of assets (e.g., land).

Funding the deficit

A fiscal deficit is often funded by issuingbonds, like treasurybills orconsols. These pay interest, either for a fixed period orindefinitely. If the interest and capital repayments are too large,a nation may default on its debts, usually to foreign creditors.

Consuming the surplus
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A fiscal surplus is often saved for future use, and may beinvested in local (same currency) financial instruments, untilneeded. When income from taxation or other sources falls, asduring an economic slump, reserves allow spending to continueat the same rate, without incurring a deficit. Hong Kong ran afiscal surplus of HK$123.6 billion in fiscal year 2007/08 (endedMarch 31, 2008), equal to US$15.85 billion or 7.7% of 2007GDP.

Economic effects of fiscal policy

Fiscal policy is used by governments to influence the level of

aggregate demand in the economy, in an effort to achieveeconomic objectives of price stability, full employment andeconomic growth. Keynesian economics suggests that adjustinggovernment spending and tax rates are the best ways tostimulate aggregate demand. This can be used in times ofrecession or low economic activity as an essential tool in

providing the framework for strong economic growth andworking toward full employment. The government can

implement these deficit-spending policies due to its size andprestige and stimulate trade. In theory, these deficits would bepaid for by an expanded economy during the boom that wouldfollow; this was the reasoning behind theNew Deal.

During periods of high economic growth, a budget surplus canbe used to decrease activity in the economy. A budget surpluswill be implemented in the economy if inflation is high, in orderto achieve the objective of price stability. The removal of fundsfrom the economy will, by Keynesian theory, reduce levels ofaggregate demand in the economy and contract it, bringingabout price stability.

Despite the importance of fiscal policy, a paradox exists. In thecase of a government running a budget deficit, funds will needto come from public borrowing (the issue of government bonds),overseas borrowing or the printing of new money. When

governments fund a deficit with the release of government
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bonds, an increase in interest rates across the market can occur.This is because government borrowing creates higher demandfor credit in the financial markets, causing a higher aggregatedemand (AD) due to the lack of disposable income, contrary tothe objective of a budget deficit. This concept is called crowdingout. Alternatively, governments may increase governmentspending by funding major construction projects. This can alsocause crowding out because of the lost opportunity for a privateinvestor to undertake the same project. Another problem is thetime lag between the implementation of the policy anddetectable effects in the economy. An expansionary fiscal policy(decreased taxes or increased government spending) is usually

intended to produce an increase in aggregate demand; however,an unchecked spiral in aggregate demand will lead to inflation.Hence, checks need to be kept in place.

ROLE OF FISCAL POLICY- ITS SIGNIFICANCE TO

BUSINESS ECONOMY IN DEVELOPING COUNTRIES

The main goal of the fiscal policy in developing countries is

the promotion of the highest possible rate of capital formation.Underdeveloped economies are in the constant deficit of thecapital in the economy and thus, in order to have balancedgrowth accelerated rate of capital formation is required. For this

purpose the fiscal policy has to be designed in a way to raise thelevel of aggregate savings and to reduce the actual and potentialconsumption of people.

To divert existing resources from unproductive to productiveand socially more desirable uses. Hence, fiscal policy must be

blended with planning for development.

To create an equitable distribution of income and wealth in thesociety.

To protect the economy from the ills of inflation and unhealthycompetition from foreign countries.

To maintain relative price stability through fiscal measures.
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The approach to fiscal policy must be aggregate as well assegmental. the sectoral imbalances can be curbed by appropriatesegmental fiscal measures.

The government expenditure on developmental planningprojects must be increased. For this deficit financing can beused. It refers to creation of additional money supply either bycreation of new money by printing by government or by

borrowing from the central bank.

Public borrowing, loans from foreign nations etc can be usedin the development of the resources for public sector.

Fiscal policy in the developing economy has to operate withinthe framework of social, cultural and political conditions whichinhibit formation and implementation of good economic

policies.

In order to reduce inequalities of wealth and distribution,taxation must be progressive and government spending must bewelfare-oriented.

The hindrances in the effective implementation of fiscal policyin the developing countries are loopholes in taxation laws,corrupt tax administration, a high population growth,extravagant governmental spending on non-developmentalitems, an orthodox society etc.

Monetary Policy

Monetary policy is the use of interest rates and the level ofthe money supply to manage the economy. Interest ratesalways used to be set by the government (the Chancellor),but the incoming Labour government in 1997 passedcontrol over interest rates to the Bank of England. The'operational independence' of the Bank of England meansthat it can set targets for inflation and set interest rates at


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the level most appropriate to achieve those targets. Thelevel is set at monthly meetings of the 'Monetary PolicyCommittee' . A majority decision of the Committee is allthat is required to change the level of interest rates.

Monetary policy may be used either to reflate theeconomy or to deflate the economy. To find out moreabout each of these and how monetary policy changesmay affect the rest of the economy follow the links belowor at the foot of the page:

Monetary policy is the process by which the government,

central bank, or monetary authority of a country controls (i) thesupply ofmoney, (ii) availability of money, and (iii) cost ofmoney or rate ofinterest, in order to attain a set of objectivesoriented towards the growth and stability of the economy.Monetary theory provides insight into how to craft optimalmonetary policy.

Monetary policy is generally referred to as either being anexpansionary policy, or a contractionary policy, where anexpansionary policy increases the total supply of money in theeconomy, and a contractionary policy decreases the total moneysupply. Expansionary policy is traditionally used to combatunemployment in a recession by lowering interest rates, whilecontractionary policy involves raising interest rates in order tocombat inflation. Monetary policy should be contrasted withfiscal policy, which refers to government borrowing, spendingand taxation.

Overview

Monetary policy rests on the relationship between the rates ofinterest in an economy, that is the price at which money can be

borrowed, and the total supply of money. Monetary policy uses

a variety of tools to control one or both of these, to influenceoutcomes like economic growth, inflation, exchange rates with
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other currencies and unemployment. Where currency is under amonopoly of issuance, or where there is a regulated system ofissuing currency through banks which are tied to a central bank,the monetary authority has the ability to alter the money supplyand thus influence the interest rate (in order to achieve policygoals). The beginning of monetary policy as such comes fromthe late 19th century, where it was used to maintain the goldstandard.

A policy is referred to as contractionary if it reduces the size ofthe money supply or raises the interest rate. An expansionary

policy increases the size of the money supply, or decreases the

interest rate. Furthermore, monetary policies are described asaccommodative in the following cases: if the interest rate set bythe central monetary authority is intended to create economicgrowth; neutral if it is intended to neither create growth norcombat inflation; or tight if intended to reduce inflation.

There are several monetary policy tools available to achievethese ends: increasing interest rates by fiat; reducing the

monetary base; and increasing reserve requirements. All havethe effect of contracting the money supply; and, if reversed,expand the money supply. Since the 1970s, monetary policy hasgenerally been formed separately from fiscal policy. Even priorto the 1970s, the Bretton Woods system still ensured that mostnations would form the two policies separately.

Within almost all modern nations, special institutions (such asthe Bank of England, the European Central Bank, the FederalReserve System in the United States, the Bank of Japan or

Nippon Gink, the Bank of Canada or the Reserve Bank ofAustralia) exist which have the task of executing the monetary

policy and often independently of the executive. In general,these institutions are called central banks and often have otherresponsibilities such as supervising the smooth operation of thefinancial system.
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The primary tool of monetary policy is open market operations.This entails managing the quantity of money in circulationthrough the buying and selling of various credit instruments,foreign currencies or commodities. All of these purchases orsales result in more or less base currency entering or leavingmarket circulation.

Usually, the short term goal of open market operations is toachieve a specific short term interest rate target. In otherinstances, monetary policy might instead entail the targeting of aspecific exchange rate relative to some foreign currency or elserelative to gold. For example, in the case of the USA the Federal

Reserve targets the federal funds rate, the rate at which memberbanks lend to one another overnight; however, the monetarypolicy of China is to target the exchange rate between theChinese renminbi and a basket of foreign currencies.

The other primary means of conducting monetary policyinclude: (i) Discount window lending (i.e. lender of last resort);(ii) Fractional deposit lending (i.e. changes in the reserve

requirement); (iii) Moral suasion (i.e. cajoling certain marketplayers to achieve specified outcomes); (iv) "Open mouthoperations" (i.e. talking monetary policy with the market).

History of monetary policy

Monetary policy is primarily associated with interest rate andcredit. For many centuries there were only two forms ofmonetary policy: (i) Decisions about coinage; (ii) Decisions to

printpaper money to create credit. Interest rates, while nowthought of as part of monetary authority, were not generallycoordinated with the other forms of monetary policy during thistime. Monetary policy was seen as an executive decision, and
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was generally in the hands of the authority with seigniorage, orthe power to coin. With the advent of larger trading networkscame the ability to set the price between gold and silver, and the

price of the local currency to foreign currencies. This officialprice could be enforced by law, even if it varied from the marketprice.

With the creation of the Bank of England in 1694, whichacquired the responsibility to print notes and back them withgold, the idea of monetary policy as independent of executiveaction began to be established.[3] The goal of monetary policywas to maintain the value of the coinage, print notes which

would trade at par to specie, and prevent coins from leavingcirculation. The establishment of central banks byindustrializing nations was associated then with the desire tomaintain the nation's peg to the gold standard, and to trade in anarrowband with other gold-backed currencies. To accomplishthis end, central banks as part of the gold standard began settingthe interest rates that they charged, both their own borrowers,and other banks who required liquidity. The maintenance of a

gold standard required almost monthly adjustments of interestrates.

During the 1870-1920 period the industrialized nations set upcentral banking systems, with one of the last being the FederalReserve in 1913.[4] By this point the understanding of the central

bank as the "lender of last resort" was understood. It was alsoincreasingly understood that interest rates had an effect on the

entire economy, in no small part because of the marginalrevolution in economics, which focused on how many more, orhow many fewer, people would make a decision based on achange in the economic trade-offs. It also became clear thatthere was abusiness cycle, and economic theory beganunderstanding the relationship of interest rates to that cycle.(Nevertheless, steering a whole economy by influencing theinterest rate has often been described as trying to steer an oil

tanker with a canoe paddle.) Research by Cass Business Schoolhas also suggested that perhaps it is the central bank policies of
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expansionary and contractionary policies that are causing theeconomic cycle; evidence can be found by looking at the lack ofcycles in economies before central banking policies existed.

The advancement of monetary policy as a pseudo scientificdiscipline has been quite rapid in the last 150 years, and it hasincreased especially rapidly in the last 50 years. Monetary

policy has grown from simply increasing the monetary supplyenough to keep up with both population growth and economicactivity. It must now take into account such diverse factors as:

short term interest rates;

long term interest rates; velocity of money through the economy;

exchange rates;

credit quality;

bonds and equities (corporate ownership and debt);

government versus private sector spending/savings;

international capital flows of money on large scales;

financial derivatives such as options, swaps, futurescontracts, etc.

A small but vocal group of people advocate for a return to thegold standard (the elimination of the dollar's fiat currency statusand even of the Federal Reserve Bank). Their argument is

basically that monetary policy is fraught with risk and theserisks will result in drastic harm to the populace should monetary

policy fail. Others see another problem with our currentmonetary policy. The problem for them is not that our moneyhas nothing physical to define its value, but that fractionalreserve lending of that money as a debt to the recipient, ratherthan a credit, causes all but a small proportion of society(including all governments) to be perpetually in debt.
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In fact, many economists disagree with returning to a goldstandard. They argue that doing so would drastically limit themoney supply, and throw away 100 years of advancement inmonetary policy. The sometimes complex financial transactionsthat make big business (especially international business) easierand safer would be much more difficult if not impossible.Moreover, shifting risk to different people/companies thatspecialize in monitoring and using risk can turn any financialrisk into a known dollar amount and therefore make business

predictable and more profitable for everyone involved.

Trends in central banking

The central bank influences interest rates by expanding orcontracting the monetary base, which consists ofcurrency incirculation and banks' reserves on deposit at the central bank.The primary way that the central bank can affect the monetary

base is by open market operations or sales and purchases ofsecond hand government debt, or by changing the reserverequirements. If the central bank wishes to lower interest rates, it

purchases government debt, thereby increasing the amount ofcash in circulation or creditingbanks' reserve accounts.Alternatively, it can lower the interest rate on discounts oroverdrafts (loans to banks secured by suitable collateral,specified by the central bank). If the interest rate on suchtransactions is sufficiently low, commercial banks can borrowfrom the central bank to meet reserve requirements and use theadditional liquidity to expand their balance sheets, increasing

the credit available to the economy. Lowering reserverequirements has a similar effect, freeing up funds for banks toincrease loans or buy other profitable assets.

A central bank can only operate a truly independent monetarypolicy when the exchange rate is floating.[5] If the exchange rateis pegged or managed in any way, the central bank will have to

purchase or sell foreign exchange. These transactions in foreignexchange will have an effect on the monetary base analogous toopen market purchases and sales of government debt; if the
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central bank buys foreign exchange, the monetary base expands,and vice versa. But even in the case of a pure floating exchangerate, central banks and monetary authorities can at best "leanagainst the wind" in a world where capital is mobile.

Accordingly, the management of the exchange rate willinfluence domestic monetary conditions. In order to maintain itsmonetary policy target, the central bank will have to sterilize oroffset its foreign exchange operations. For example, if a central

bank buys foreign exchange (to counteract appreciation of theexchange rate), base money will increase. Therefore, to sterilizethat increase, the central bank must also sell government debt to

contract the monetary base by an equal amount. It follows thatturbulent activity in foreign exchange markets can cause acentral bank to lose control of domestic monetary policy when itis also managing the exchange rate.

In the 1980s, many economists began to believe that making anation's central bank independent of the rest ofexecutivegovernment is the best way to ensure an optimal monetary

policy, and those central banks which did not haveindependence began to gain it. This is to avoid overtmanipulation of the tools of monetary policies to effect politicalgoals, such as re-electing the current government. Independencetypically means that the members of the committee whichconducts monetary policy have long, fixed terms. Obviously,this is a somewhat limited independence.

In the 1990s, central banks began adopting formal, publicinflation targets with the goal of making the outcomes, if not the

process, of monetary policy more transparent. In other words, acentral bank may have an inflation target of 2% for a given year,and if inflation turns out to be 5%, then the central bank willtypically have to submit an explanation.

The Bank of England exemplifies both these trends. It becameindependent of government through the Bank of England Act
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1998 and adopted an inflation target of 2.5% RPI (now 2% ofCPI).

The debate rages on about whether monetary policy can smooth

business cycles or not. A central conjecture ofKeynesianeconomics is that the central bank can stimulate aggregatedemand in the short run, because a significant number of pricesin the economy are fixed in the short run and firms will produceas many goods and services as are demanded (in the long run,however, money is neutral, as in the neoclassical model). Thereis also the Austrian school of economics, which includesFriedrich von Hayekand Ludwig von Mises's arguments, but

most economists fall into either the Keynesian or neoclassicalcamps on this issue.

Developing countries

Developing countries may have problems establishing aneffective operating monetary policy. The primary difficulty isthat few developing countries have deep markets in governmentdebt. The matter is further complicated by the difficulties inforecasting money demand and fiscal pressure to levy theinflation tax by expanding the monetary base rapidly. In general,the central banks in many developing countries have poorrecords in managing monetary policy. This is often because themonetary authority in a developing country is not independentof government, so good monetary policy takes a backseat to the

political desires of the government or are used to pursue othernon-monetary goals. For this and other reasons, developingcountries that want to establish credible monetary policy mayinstitute a currency board or adopt dollarisation. Such forms ofmonetary institutions thus essentially tie the hands of thegovernment from interference and, it is hoped, that such policieswill import the monetary policy of the anchor nation.

Recent attempts at liberalizing and reforming the financialmarkets (particularly the recapitalization of banks and other

financial institutions inNigeria and elsewhere) are gradually
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providing the latitude required in order to implement monetarypolicy frameworks by the relevant central banks.

Types of monetary policy

In practice, all types of monetary policy involve modifying theamount of base currency (M0) in circulation. This process ofchanging the liquidity of base currency through the open salesand purchases of (government-issued) debt and creditinstruments is called open market operations.

Constant market transactions by the monetary authority modify

the supply of currency and this impacts other market variablessuch as short term interest rates and the exchange rate.

The distinction between the various types of monetary policylies primarily with the set of instruments and target variablesthat are used by the monetary authority to achieve their goals.

MonetaryPolicy:

Target MarketVariable:

Long Term Objective:

InflationTargeting

Interest rate onovernight debt

A given rate of change inthe CPI

Price LevelTargeting

Interest rate onovernight debt

A specific CPI number

MonetaryAggregates

The growth inmoney supply

A given rate of change inthe CPI

FixedExchange Rate

The spot price ofthe currency

The spot price of thecurrency

Gold StandardThe spot price ofgold

Low inflation as measuredby the gold price

Mixed PolicyUsually interestrates

Usually unemployment +CPI change

The different types of policy are also called monetary regimes,in parallel to exchange rate regimes. A fixed exchange rate is
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also an exchange rate regime; The Gold standard results in arelatively fixed regime towards the currency of other countrieson the gold standard and a floating regime towards those that arenot. Targeting inflation, the price level or other monetaryaggregates implies floating exchange rate unless themanagement of the relevant foreign currencies is tracking theexact same variables (such as a harmonised consumer priceindex).

Inflation targeting

Inflation targeting:

Under this policy approach the target is to keep inflation, undera particular definition such as Consumer Price Index, within adesired range.

The inflation target is achieved through periodic adjustments tothe Central Bankinterest rate target. The interest rate used isgenerally the interbank rate at which banks lend to each otherovernight for cash flow purposes. Depending on the country this

particular interest rate might be called the cash rate or somethingsimilar.

The interest rate target is maintained for a specific durationusing open market operations. Typically the duration that theinterest rate target is kept constant will vary between monthsand years. This interest rate target is usually reviewed on amonthly or quarterly basis by a policy committee.

Changes to the interest rate target are made in response tovarious market indicators in an attempt to forecast economictrends and in so doing keep the market on track towardsachieving the defined inflation target. For example, one simplemethod of inflation targeting called the Taylor rule adjusts theinterest rate in response to changes in the inflation rate and theoutput gap. The rule was proposed by John B. Taylorof

Stanford University.
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The inflation targeting approach to monetary policy approachwas pioneered in New Zealand. It is currently used in Australia,Canada, Chile, the Eurozone,New Zealand,Norway, Poland,Sweden, South Africa, Turkey, and the United Kingdom.

Price level targeting

Price level targeting is similar to inflation targeting except thatCPI growth in one year is offset in subsequent years such thatover time the price level on aggregate does not move.

Something similar to price level targeting was tried by Swedenin the 1930s, and seems to have contributed to the relativelygood performance of the Swedish economy during the GreatDepression. As of 2004, no country operates monetary policy

based on a price level target.

Monetary aggregates

In the 1980s, several countries used an approach based on aconstant growth in the money supply. This approach was refinedto include different classes of money and credit (M0, M1 etc). Inthe USA this approach to monetary policy was discontinuedwith the selection ofAlan Greenspan as Fed Chairman.

This approach is also sometimes called monetarism.

While most monetary policy focuses on a price signal of one

form or another, this approach is focused on monetaryquantities.

Fixed exchange rate

This policy is based on maintaining a fixed exchange rate with aforeign currency. There are varying degrees of fixed exchangerates, which can be ranked in relation to how rigid the fixed

exchange rate is with the anchor nation.
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Under a system of fiat fixed rates, the local government ormonetary authority declares a fixed exchange rate but does notactively buy or sell currency to maintain the rate. Instead, therate is enforced by non-convertibility measures (e.g. capitalcontrols, import/export licenses, etc.). In this case there is a

black market exchange rate where the currency trades at itsmarket/unofficial rate.

Under a system of fixed-convertibility, currency is bought andsold by the central bank or monetary authority on a daily basisto achieve the target exchange rate. This target rate may be afixed level or a fixed band within which the exchange rate may

fluctuate until the monetary authority intervenes to buy or sell asnecessary to maintain the exchange rate within the band. (In thiscase, the fixed exchange rate with a fixed level can be seen as aspecial case of the fixed exchange rate with bands where the

bands are set to zero.)

Under a system of fixed exchange rates maintained by acurrency board every unit of local currency must be backed by a

unit of foreign currency (correcting for the exchange rate). Thisensures that the local monetary base does not inflate withoutbeing backed by hard currency and eliminates any worries abouta run on the local currency by those wishing to convert the localcurrency to the hard (anchor) currency.

Under dollarization, foreign currency (usually the US dollar,hence the term "dollarisation") is used freely as the medium ofexchange either exclusively or in parallel with local currency.This outcome can come about because the local population haslost all faith in the local currency, or it may also be a policy ofthe government (usually to rein in inflation and import crediblemonetary policy).

These policies often abdicate monetary policy to the foreignmonetary authority or government as monetary policy in the

pegging nation must align with monetary policy in the anchor

nation to maintain the exchange rate. The degree to which local
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monetary policy becomes dependent on the anchor nationdepends on factors such as capital mobility, openness, creditchannels and other economic factors.

Monetary policy theory

It is important for policymakers to make credible

announcements and degrade interest rates as they are non-important and irrelevant in regarding to monetary policies. If

private agents (consumers and firms) believe that policymakersare committed to lowering inflation, they will anticipate future

prices to be lower than otherwise (how those expectations areformed is an entirely different matter; compare for instancerational expectations with adaptive expectations). If anemployee expects prices to be high in the future, he or she will

draw up a wage contract with a high wage to match these prices.Hence, the expectation of lower wages is reflected in wage-setting behaviour between employees and employers (lowerwages since prices are expected to be lower) and since wagesare in fact lower there is no demand pull inflation becauseemployees are receiving a smaller wage and there is no cost

push inflation because employers are paying out less in wages.

In order to achieve this low level of inflation, policymakersmust have credible announcements; that is, private agents must

believe that these announcements will reflect actual futurepolicy. If an announcement about low-level inflation targets ismade but not believed by private agents, wage-setting willanticipate high-level inflation and so wages will be higher andinflation will rise. A high wage will increase a consumer'sdemand (demand pull inflation) and a firm's costs (cost push

inflation), so inflation rises. Hence, if a policymaker's
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announcements regarding monetary policy are not credible,policy will not have the desired effect.

If policymakers believe that private agents anticipate low

inflation, they have an incentive to adopt an expansionistmonetary policy (where the marginal benefit of increasingeconomic output outweighs the marginal cost of inflation);however, assuming private agents have rational expectations,they know that policymakers have this incentive. Hence, privateagents know that if they anticipate low inflation, an expansionist

policy will be adopted that causes a rise in inflation.Consequently, (unless policymakers can make their

announcement of low inflation credible), private agents expecthigh inflation. This anticipation is fulfilled through adaptiveexpectation (wage-setting behaviour);so, there is higher inflation(without the benefit of increased output). Hence, unless credibleannouncements can be made, expansionary monetary policy willfail.

Announcements can be made credible in various ways. One is to

establish an independent central bank with low inflation targets(but no output targets). Hence, private agents know that inflationwill be low because it is set by an independent body. Central

banks can be given incentives to meet their targets (for example,larger budgets, a wage bonus for the head of the bank) in orderto increase their reputation and signal a strong commitment to a

policy goal. Reputation is an important element in monetarypolicy implementation. But the idea of reputation should not be

confused with commitment. While a central bank might have afavorable reputation due to good performance in conductingmonetary policy, the same central bank might not have chosenany particular form of commitment (such as targeting a certainrange for inflation). Reputation plays a crucial role indetermining how much would markets believe theannouncement of a particular commitment to a policy goal but

both concepts should not be assimilated. Also, note that under

rational expectations, it is not necessary for the policymaker tohave established its reputation through past policy actions; as an
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example, the reputation of the head of the central bank might bederived entirely from her or his ideology, professional

background, public statements, etc. In fact it has been argued(add citation to Kenneth Rogoff, 1985. "The OptimalCommitment to an Intermediate Monetary Target" in 'QuarterlyJournal of Economics' #100, pp. 1169-1189) that in order to

prevent some pathologies related to the time-inconsistency ofmonetary policy implementation (in particular excessiveinflation), the head of a central bank should have a largerdistaste for inflation than the rest of the economy on average.Hence the reputation of a particular central bank is not necessarytied to past performance, but rather to particular institutional

arrangements that the markets can use to form inflationexpectations.

fiscal economics policy

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