The problem of temporal inconsistency arises when a policymaker makes an announcement of a policy, but at the time of its implementation, performs another; this after people have already taken their decisions based on the first announcement. In doing so, policymakers are trying to improve the economic welfare of society, but these inconsistent actions will eventually lead to other outcome.
The intervention of the state in economics was justified through Keynes’s Macroeconomic Theory (1936), which arose after the Great Depression in 1929. Around 50, it was believed that the best way to conduct monetary policy was through the opacity of the Central bank shares, as it would be easier to obtain the desired results (MENDONÇA, 2006).
The Keynesian Model, however, was losing supporters because of the lack of microfoundation, which invalidated the policy councils based on conclusions of large-scale macroeconomic models. Lucas’ Critique (1976) was based on the fact that the parameters of these models were not invariant relative to politics, since they would necessarily suffer changes.
The rise of neoclassical ideas was led by Robert Lucas and followed by other economists who supported the revolution on rational expectations (MONTES, 2009). In this model, individual agents will base their decisions on the best information available, though people may be wrong some of the time, on average they will be correct and they are the best guess for the future. That is assumed that people learn from past mistakes.
The incorporation of rational expectations to economic policy and contrary evidences to the Keynesian approach, which associated with the trade off inflation versus unemployment present at the original Phillips curve, led to a change of this pattern in the theoretical analysis of politics Monetary, which was reference until mid-1970 (MENDONÇA, 2006).
From then on, the argument that monetary policy should be concerned with low and stable inflation has been supported by rational expectations and the natural rate of unemployment. The theoretical justification for adopting the inflation targets regime began with Kydland and Prescott (1977), known as “rules versus description”. They initiated their studies on the credibility of monetary policy where they stated that the use of rules for driving would represent the best solution for the current policy to be consistent with the future equilibrium policy.
Following this same line, Barro and Gordon (1983) highlighted the importance of the role of reputation for conducting monetary policy, since persistence of inflation is attributed to non-compliance with the ads previously signed with society. In this way, it has become necessary to seek ways to resolve the problem of inflationary bias arising from monetary policy. According to Barro (1986), the disinflation of the economy can result in a greater sacrifice than necessary for society.
According to Inhudes and Mendonça (2010), the current trend for central banks is to increase transparency for the conduct of monetary policy. In line with this thinking, since 1990 the inflation targeting regime has been adopted by several central banks. The main characteristic is the announcement of levels for the fluctuation of inflation, recognizing that monetary policy aims to maintain low and stable inflation (MONTES,CURI, 2014). The adoption of this policy is linked to greater transparency of the central bank, increasing its responsibility and also credibility.
Mishkin (2004) studied the issues that need to be addressed in order for the inflation targeting regime to work effectively in emerging economies. He argued that the developments of fiscal, financial and monetary institutions are key to achieving successful implementation. According to him, this regime results in a reduction in the problem of inconsistency and increase in the accountability of the economic policy-maker.
Mendonça et al. (2012) analyzed the policy of adopting inflation targets for developing economies and concluded that it represents a good strategy, since it reduces the volatility of inflation, leading to acceptable levels in the international scenario. In general, developing economies have experienced hyperinflation, resulting in a fragility of central bank communication and transparency.
In this way, the analysis of the effects caused by the expectation of inflation is important for the developing economies. This analysis seeks to answer whether the inflation targeting regime is able to mitigate discretionary actions by the Central Bank of Colombia and, therefore, the occurrence of the problem of inconsistency over time.Colombia adopted inflation targeting in November of 2001 and the analysis focuses on the period after the adoption of inflation targeting, from 2001 to 2014.
The constitutional mandate to maintain a low and stable inflation, in coordination with general economic policy is the Junta Directiva del Banco de la República’s (JDBR) responsibility. The model was adopted to control the actions of monetary policy, maintaining a low inflation rate and achieving a level of output consistent with the capacity of the economy. In Colombia, the goal refers to inflation in consumer prices, which is measured by the annual variation in the Consumer Price Index (IPC), calculated by the National Bureau of Statistics (DANE).
In 1991, the JDBR decided to abandon the currency bands regime, implementing a flexible exchange rate regime and the first Report on Inflation was published. Later, new indicators and predictive models were built to allowed the consolidation of the strategy targets for inflation. In November 2001, the JDBR reported that long-term target for inflation was 3% and explained that maintaining the purpose was equivalent to lean towards a price stability in the country. In 2002 it was given the beginning of a track around a specific goal for the coming year, in order to control the growth of prices of the basic basket of families and ensuring the purchasing power of money. Thus, in mid-2009, inflation was around 3%, and as of 2010 the band established goal, which was between 2% and 4%, has focused on the long-term goal.
Monetary policy decisions are made based on the current analysis of the state from the perspective of the economy as well as in evaluating the forecast and expectations of inflation considering the long-term 3% target. Thus, the Junta Directiva del Banco de la República determines the value of its main monetary policy instrument, the basic interest rate. This fee level will allow to stabilize inflation in the policy horizon, ranging from 6 months to 2 years, in 3% and contributes to the product converge to long-term level.
The main criteria for setting the basic interest rate are:
• When the present analysis and future inflation indicate that there is possibility of permanent deviation of 3%, the prime rate changes to lead the inflation, in sufficient time, to the long-term goal.
• The intervention in the basic interest rate in order to maintain an appropriate balance between the achievement of the inflation target and the purpose of smoothing fluctuations in product and employment around its path of sustainable growth. That means that Colombia’s inflation strategy is flexible: it concerns keeping inflation at 3% and to avoid overspending or overproduction capacity.
• Banco de la República’s policy also seeks to contribute, together with other responsible entities, to mitigate the risk of financial statements unbalanced, those were understood as leverage excesses of assets or prices thet compromises financial stability. Avoid these imbalances makes it easier so the economy work close to its path of sustainable growth horizons of medium and long term.
These criteria should be incorporated seeking a balance between them. The basic interest rate adjusts gradually, except in conditions in which, with a high probability or certainty, the economy threatens to deviate considerably from the inflation target and/or its path of sustainable growth.
In the seminal article of Ireland (1999), the time-inconsistency problem is studied by testing the existence of cointegration between inflation and unemployment rate series. In the work of Gupta and Uwilingiye (2010), the time-inconsistency problem is studied by testing the existence of cointegration between inflation and GDP. In the present article, we will consider the results of both cointegration tests: inflation and unemployment series as well as inflation and output series.
A necessary condition for testing for a long-run relationship between two variables is that these variables are I(1), i.e., stationary in first differences. Once that it is observed it is possible to proceed to test for a long-run relationship between the series. If such a relationship exists and the signs of the coefficients are positive, it is possible that the time-inconsistency problem is occurring.
Regarding the findings for the relation between inflation and unemployment and for the relation between inflation and output, the results do not support the model’s implications for the long run, and thus monetary policy is not inconsistent. The findings suggest for 2001-2014 that inflation and unemployment are not cointegrated. In this sense, considering the monetary authority’s possibility to exploit the trade-offs in the Colombian economy, it seems that, under inflation targeting, there is no strong evidence of time-inconsistency problem of the monetary policy for the period.
The Colombian experience with inflation targeting looks quite successful. Inflation fell from levels above 15%, when inflation projections were first introduced, to a level around 3%. The results allow one to conjecture that the traditional argument that the adoption of inflation targeting can avoid the time-inconsistency problem is true for the Colombian case. Although developing countries present a fertile ground for the occurrence of the time-inconsistency problem due to the history of weak institutions and lack of commitment on the part of policymakers, this is not the case when Colombian is considered.
BARRO, R. J., GORDON, D. B., 1983. Rules, discretion and reputation in a model of monetary policy. Journal of Monetary Economics 12(1), 101-121.
BARRO, R. J. Recent developments in the theory of rules versus discretion. The Economic Journal, v. 96, p. 2337, 1986.
El Proceso de Toma de Decisiones de Politica Monetaria, Cambiaria y Crediticia Del Banco de La Republica. Available at: http://www.banrep.gov.co/sites/default/files/paginas/anexo_re_transparencia.pdf
GUPTA, R., UWILINGIYE, J., 2010. Dynamic time inconsistency and the South African Reserve Bank. South African Journal of Economics 78(1), 76-88.
INHUDES, Adriana, MENDONÇA, H.F. Transparência do Banco Central: uma análise para o caso brasileiro. Revista de economia política. Vol. 30. nº 1. São Paulo. Março 2010
KYDLAND, F. E., PRESCOTT, E. C. Rules rather than discretion: the inconsistency of optimal plans. Journal of Political Economic, v. 85, n. 3, p. 473492,1977.
LUCAS, R. (1976), “Econometric Policy Evaluation: A Critique”, Carnegie-Rochester Conference Series on Public Policy. Available at: http://nobelprize.org/nobel_prizes/economics/laureates/1995/press.html
MENDONÇA, H. F., de GUIMARÃES e SOUZA, G. J., 2012. Is inflation targeting a good remedy to control inflation? Journal of Development Economics 98(2), 178-191.
MENDONÇA, H. F., Transparência, condução da política monetária e metas para inflação. Nova econ. vol.16 no.1 Belo Horizonte Jan./Apr. 2006
MISHKIN, F. S. Can inflation targeting work in emerging market countries?
- (NBER Working Papers Series, WP 10646). Disponível em:
MONTES, G. C. Política monetária, inflação e crescimento econômico:a influência da reputação da autoridade monetária sobre a economia. Economia e Sociedade, Campinas, v. 18, n. 2 (36), p. 237-259, ago. 2009.
MONTES, G. C., CURI, A. . The Importancy Of Credibility For The Conduct Of Monetary Policy And Inflation Control. In: 1o Encontro de Economia Aplicada da UFJF, 2014, Juiz de Fora. 1o Encontro de Economia Aplicada da UFJF, 2014. v. 1.
MONTES, G. C., VEREDA, L. ; NICOLAY, R. T. F. ; CURI, A. . Effects of transparency, monetary policy signaling and clarity of central bank communication on disagreement about inflation expectations. In: 37o Encontro Brasileiro de Econometria – SBE, 2015, Florianópolis. 37o Encontro Brasileiro de Econometria – SBE, 2015. v. 37. p. 1-20.