Created 3/10/1998
Go to DeLong's Home Page

What Central Banks Fear Most: The Loss of Credibility

J. Bradford DeLong

When workers, firms, and investors lose confidence in a central bank's commitment to price stability, the expected inflation rate too rises. This shifts the aggregate supply curve upward.

Such a loss of credibility looks exactly like a supply shock. The central bank can (a) expand the money supply to keep the upward shift in the aggregate supply curve from causing a recession, at the cost of higher inflation; or (b) keeping the loss of confidence from generating higher inflation by raising interest rates, creating deep recession.

Neither alternative is appetizing.

So central banks jealously guard their credibility as inflation-fighters.

The Dilemma of Stagflation      

Professor of Economics J. Bradford DeLong, 601 Evans Hall, #3880
University of California at Berkeley
Berkeley, CA 94720-3880
(510) 643-4027 phone (510) 642-6615 fax

This document:

Search This Website