Credibility Dynamics and Disinflation Plans

IMF Working Papers, June 5, 2020

Source details

Authors: Bomakara Heng (National Bank of Cambodia), Francisco Roldán
Date: June 5, 2020
Core research question: Optimal design of a disinflation plan by a planner who lacks commitment.
Central mechanism studied: Tradeoff between surprise inflation and building reputation, where reputation is defined as the private sector's belief that the Central bank is committed to the plan.
Main conclusion: Even in the zero reputation limit, a gradual disinflation is preferred despite the absence of inflation inertia in the private economy.

Some disinflation plans are harder to sustain because "paving out future grounds with temptation" leads to a negative drift of reputation in equilibrium.
Successful plans balance promises of lower inflation with dynamic incentives that increase credibility.
The planner anticipates interactions between announced promises and reputation dynamics when announcing the disinflation plan.
Preference for gradual disinflation holds even when reputation is effectively zero and when the private economy lacks inflation inertia.

Reputation is modeled as the private sector's belief about the Central bank's commitment to the announced plan.
A tradeoff exists between:
- Surprise inflation (deviating from the announced plan), and
- Building reputation (sustaining low inflation expectations over time).
Dynamic incentives embedded in the announced plan can offset temptations to deviate and prevent negative reputation drift.
The equilibrium features endogenous reputation dynamics; some plans induce a negative drift of reputation, making them unsustainable.

When designing disinflation plans without full commitment, policymakers should:
- Balance short-term promises of lower inflation with mechanisms that create credible dynamic incentives.
- Favor gradual disinflation strategies even when initial credibility is extremely low or absent.
- Recognize that certain plan designs may inherently erode reputation over time and should be avoided.

Subject: Disinflation, Inflation, Inflation targeting, Monetary policy, Prices, Tax incentives
Keywords: choice of policy, Disinflation, equilibrium announcement, government being, government credibility, government's choice, high-inflation stage Nash, Imperfect credibility, Inflation, inflation plan, Inflation targeting, Nash inflation, optimal monetary policy, Phillips curve, punishment regime, rational government, reputation, time inconsistency, WP