Dealing with Time-Inconsistency: Inflation Targeting vs. Exchange Rate Targeting

Abstract

Abandoning an objective function with multiple targets and adopting a single mandate can be an effective way for a central bank to overcome the classic time-inconsistency problem. We show that the choice of a particular single mandate depends on an economy’s level of trade openness and the credibility of the central bank. We begin with reduced form empirical results which show that as central banks become less credible they are more likely to adopt a pegged exchange rate, and crucially, the tendency to peg depends on trade openness. Then in a model where the central bank displays “loose commitment” we show that as central bank credibility falls, they are more likely to adopt either an inflation target or a pegged exchange rate. A relatively closed economy would adopt an inflation target to overcome the time-inconsistency problem, but a highly open economy would prefer an exchange rate peg.