Politics and Monetary Policy

Michael EhrmannMarcel Fratzscher

European Central Bank

Comments:

William Roberts ClarkUniversity of Michigan

wrclark@umich.edu

Summary/Goals

Show that central bankers are “conservative” in the Rogoff sense (more willing to accept reduced growth in

exchange for price stability) Show that ECB is different because it cares

about Euro-Area whereas politicians also care (i.e. respond to) about differential between their country and Euro-Area’s macroeconomic conditions

Strategy

Assume “silence is consent” and the converse:

calls for lower interest rates reveals politicians are less “conservative” than CB

What Politicians want

That is, interest rates are increasing in inflation and output and increases in inflation and growth differentials

The difference between these is the difference between politician’s and CB’s ideal policy

Yes!

Maybe not (if we relax linearity assumption)

The difference may depend on where one is in the business cycle

i*

growth

CB’s reaction function

Politician’s reaction function

IF and interest rate reveals the preferences of the CB AND politicians advocate changes in policy iff they disagree with cb, then

The propensity to complain about interest rates is increasing in difference between CB and Politician’s ideal interest rates:

Increase in EA inf leads to a bigger change in preferred interest rate of CP than the politicians

Increase in EA gwth leads to a smaller change in preferred interest rate of CP than the politicians

Results

Next the authors text whether time varying factors influence politician’s preferences

Allows authors to compare normal times:

With times of exceptional political pressure:

Results

Pre ElectionLow Voting Support

Low Trust inECB

Excessive Deficit

negative growth differential LEFT party

inflationEA b1>0 -0.609 -5.34 -0.372 -0.525 -0.284 -0.775

yEA c1<0 -0.132 -0.151 -0.171 -0.086 -0.169 -0.067

InfDIFF b2 <0 -0.468 -0.435 -0.424 -0.495 -0.258 -0.602

yDIFF c2 <0 -0.087 -0.109 -0.016 -0.069 0.062 -0.034

InfEA * X b3>0 1.132 -0.016 -0.55 -0.094 -0.35 0.018

yEA * X c3<0 -0.332 -0.001 -0.08 -0.518 -0.062 -0.148

InfDiff * X b4 = ? 0.29 -0.005 0.038 0.016 -0.507 0.216

yDIFF * X c4 <0 0.139 0.005 -0.344 -0.175 -0.235 -0.432

X d -1.874 0.035 1.203 1.061 1.553 -0.095

Compare regular vs. acute political pressures

InflationEA Pre ElectionLow Voting Support

Low Trust inECB

Excessive Deficit

negative growth differential LEFT party

WHEN x=-1 -1.568

WHEN X =0 -0.609 -0.372 -0.525 -0.284 -0.775

WHEN X=1 0.523 -0.922 -0.619 -0.634 -0.757

interaction term sig? yes no no no no no

In the absence of political pressures, an increase in inflationEA has no effect on political demands

when political pressures are present,there is little evidence anything changes

GrowthEAWHEN x=-1 0.081

WHEN X =0 -0.132 -0.171 -0.086 -0.169 -0.067

WHEN X=1 -0.464 -0.251 -0.604 -0.231 -0.215

interaction term sig? no no no yes no no

results somewhat mixed

Growth Differential

WHEN x=-1

WHEN X =0 -0.087 -0.016 -0.069 0.062 -0.034

WHEN X=1 0.052 -0.36 -0.244 -0.173 -0.466

interaction term sig? no no yes no yes yes

INFLATION DIFFERENCEWHEN x=-1 -0.818WHEN X =0 -0.468 -0.424 -0.495 -0.258 -0.602WHEN X=1 -0.178 -0.386 -0.479 -0.765 -0.386interaction term sig? yes no no no no no

in the absence of acute political pressures, an increase in the infation differentail leads to a decrease in demands for lower rates

when accute political pressures are present, there is no relation (consistent with indeterminacy of the hypothesis)

What are the effect of acute political pressures?

“There are PE factors that make politicians shift their preferences even more strongly towards growth, and away from price stability

particularly true when:

1) Growth is low

2) Trust is low

3) When left wing is in power

Evidence for these claims can’t be found by looking at d

Three Possible Responses

Exit Accept that there has been a deleterious change in your environment and alter your behavior to optimize in the new environment.

VoiceUse your ‘voice’ (complain, protest, lobby, take direct action) to try and change the environment back to its original condition.

LoyaltyAccept the fact that your environment has changed and make no changes to your behavior.

The Set-Up

Pre-history…Central bank announces an interest policy higher than preferred by politician.

Politicians must decide whether to: Accept interest rate announced by CB and adopt fiscal policies consistent with it (Accomodate)

Accept interest rate and adopt fiscal policies inconsistent with it (Punish)

Apply political pressure in an attempt to get CB to lower interest rates (PP)

Politician’s response depends on expected response of the CB to PP

High Interest Rates, Expansionary Fiscal Policy

?

Punish Accomodate

PP

High Interest Rates, Fiscal Restraint

Politician

State

State’s response depends on its expectation of citizen’s response

Punish Accommodate

BB

Citizen

Low Interest Rates, Moderate

Fiscal PolicyAccomodate

Stand Firm

?

High Interest Rates, Expansionary Fiscal Policy

High Interest Rates, Fiscal Restraint

Exit, Voice, Loyalty Game

CB

Punish Accomodate

PP

Pol

Accomodate

Stand Firm

Pol

Accomodate

Punish

High Interest Rates, Expansionary Fiscal Policy

High Interest Rates, Fiscal Restraint

Low Interest Rates, Moderate

Fiscal Policy

High Interest Rates, Fiscal Restraint

High Interest Rates, Expansionary Fiscal Policy

Turning Outcomes into Payoffs

Outcome Description Politician CB

O1 CB gets preferred monetary policy, Politician “goes nuclear” on fiscal policy

E 1

O2 CB gets preferred monetary policy, Politician accepts implied fiscal policy

0 1+L

O3 CB adopts low interest rate policy preferred by politician, politician adopts moderate fiscal policy

1-C L

O4 CB gets preferred monetary policy; Politician accepts implied fiscal policy but pays cost for using voice

0-C 1+L

O5 CB gets preferred monetary policy; Politician goes nuclear on fiscal policy an pays cost of using voice

E-C 1

Assumption: 1-C> E

Exit, Voice, Loyalty Game With Payoffs

Punish Accomodate

PP

E;1

Citizen

0;1+L

State

Accomodate

Stand Firm

Citizen

Accomodate

Punish

E-C;1

0-C;1+L

1-C;L

Punish, Punish; Ignore

PP, Punish; Accomodate

Accommodate, Accomodate; Stand

Firm

Accomodate, Accomodate; Stand

Firm

Autonomous L<1

Dependent L>1

Credible Exit 1-C>E>0

No Credible Exit E<0

CB

Politician

Summary of Sub-Game Perfect Nash Equilibria

Summary

CB is only willing to back down under two conditions:The pol must have a credible exit threat

The CB must care more about deterring unwanted fiscal policy than it cares about its preferred monetary policy.

An independent central banker never backs down

According to this little model, we learn that there is more to central bank independence than conservativism. Its one thing to WANT an interest rate lower than politicians, its another to want it enough to take whatever the politician is willing to do in response to a low inflation policy

Summary

If voice was going to be effective, why would the CB announce the high interest rate policy in the first place?

It wouldn’t have!! The CB would always do what the politicians want. Under complete information, PP is off the equilibrium path.

Just because you don’t hear politicians using their voice, doesn’t mean that they are not powerful. It may be that the CB is already doing what they want.

Margaret Thatcher “Being powerful is like being a lady. If you have to tell people you are, you aren’t”

Summary

The insight that powerful people never need to use their voice poses a big problem for empirical study of politics.

When power is most potent, it is least likely to be used.

It is hard to know who has power just by looking at the world.

Summary

The model suggests that politicians only use voice when it will be effective.

BUT we often see politicians complaining about interest rates with the CB ignoring them. Why?

Resort to “incomplete information” to explain why politicians use PP to try to convince CB that they are willing to “go nuclear”Maybe politicians do not see protesting as costly. Maybe politicians enjoy the actual use of voice even if they know they will be unsuccessful.

We can change the game to make C < 0 i.e. protesting has negative costs. When this happens, it is easy to show that the politicians always complain about interest rates.

Conclusion

The Exit, Voice, and Loyalty game reveals what politics is and how it works.

Politics is about using power to influence others while trying to avoid being influenced oneself.

“Voice” and “Exit” should be understood metaphorically here.

“Exit” may mean emigration, but it may also mean changing industry, production processes, or political parties.

The actual use of “Voice” might range from a ballot to a bullet.

The effect of Politics on Demands for Lower Interest Rates conditioned on Euro Area Growth and Inflation