Monetary Policy and Central Bank Behavior

Abstract

There are few areas in which public choice has had as much success in making inroads into mainstream economics and, in particular, in influencing real-life developments as in the design of monetary institutions and the day-to-day conduct of monetary policy. This survey tracks these developments, from the humble beginnings in the 1970s related to Nordhaus’ (1975) account of the opportunistic political business cycle to the widespread academic and political discussion on monetary policy rules and targets of today.¹ Section 2 contains a compact review of the two classical ideas in political macroeconomics, the political business cycle and the inflation bias. Section 3 moves on to more modern, stochastic models, in which the desire for undistorted stabilization of supply shocks calls for refined remedies to the time-inconsistency problem, such as performance contracts and inflation targets for central banks. Section 4 moves on to a discussion of current developments which focus on instrument and targeting rules for monetary policy. Finally, section 5 briefly assesses these developments.