Establishing Credibility: A Rational Expectations Viewpoint

Abstract

Ongoing attempts to reduce the rate of inflation through restrictive monetary policy in the United States and a number of other countries have brought practical focus to the problem of establishing the credibility of macroeconomic policy. While credibility is usually an unquestioned criterion of good public policy, in the case of disinflation it takes on special importance. Credibility about a future change in the course of policy may be able to directly reduce the costs of disinflation by changing inflationary expectations. Since inflationary expectations have a significant influence on current wage and price decisions, a reduction in actual inflation may result. To the extent that it is quantitatively significant, this expectations effect of credibility-the expectations bonus -puts a premium on establishing the credibility of a monetary disinflation program. The purpose of this paper is to consider the problem of establishing the credibility of such a program from the perspective of a rational expectations approach to macroeconomic policy evaluation. That credibility would have significant disinflation effects once established, is closely associated with the rational expectations hypothesis, and has been demonstrated both in the context of and contract-based rational expectations models. (A summary of the results from the different models is contained in my 1980 review paper.) From macroeconomic research completed during the last ten years, it now seems clear that a rational expectations approach to policy evaluation should not be confined to market-clearing situations where all prices and wages adjust instantaneously, nullifying the real effects of anticipated policy and leaving only unanticipated policy to matter. In fact, much rational expectations research in macroeconomics has given explicit attention to contracts and other rigidities which lead to infrequent adjustment of most wages and prices. In this paper, however, I will only touch on this technical research, and instead attempt to apply some of the more general principles of rational expectations to the problem of establishing credibility of macroeconomic policy at this time in the United

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