How do central banks control inflation? A guide for the perplexed
Laura Castillo-Martinez, Ricardo Reis
This article argues that the central bank rests at the center of inflation, or rather, at the center of the factors and mechanisms determining inflation. This has various key components:
- Prices: The authors construct a model of prices conditional on real outcomes. Their model does not go so far as to solve for both prices and real outcomes as a function of exogenous shocks, so in that sense, it’s an incomplete model. In this model, supply and demand alone do not pin down inflation; that requires a central bank, “whose liabilities define what prices are in the first place.”
- Controlling inflation: The authors argue that by (1) setting the interest rate on banks’ deposits at the central bank (bank reserves) in an “aggressive and transparent way”, (2) anchoring inflation expectations, and (3) having fiscal support to “prevent runs on its liabilities” (not sure what that means), the central bank can control inflation.
- Determinacy: To achieve a given inflation target, monetary policy must ensure a determinate equilibrium. Multiple or indeterminate equilibria means the policy framework is incomplete in some way. Further, the central bank must form accurate estimates of the state of the economy and communicate those transparently.
- Intertemporal budget constraint: Like all economic actors, the central bank has an intertemporal budget constraint, enforced by the unwillingness of rational private agents to “hold the liabilities of an insolvent institution.” In meeting this constraint, the central bank’s tools include expenses, the composition of its assets, and the dividends it pays to the government.