We examine the dynamic path of an economy after a change in regime, when neither the policy to be followed nor the reactions of the public are known. The model is an application of Kreps and Wilson's reputation model to Barro and Gordon's macroeconomic policy game. Equilibrium is defined to be the dynamically consistent solution to a game between the government and the private sector. It involves mixed strategies and Bayesian learning by both sides until the uncertainty about government and public behaviour is resolved. The absence of complete credibility of government policy and intransigence of private sector wage demands increase the output loss of disinflation. The analysis also sheds light on the strategic nature of economic policymaking and the role of information in macroeconomics.

In his recent paper in the American Economic Review, Jensen (1997) argues that delegation of monetary policy to an independent central bank, which acts as an agent for the government, does not mitigate the problem of time-inconsistency, but merely relocates it. ∗We acknowledge with thanks support for this work provided through ESRC research grant L138251003 “Imperfect Financial Markets, Business Cycles, and Growth”, which forms part of the programme on Understanding the Evolving Macroeconomy (UEM). We are grateful to participants at the Money, Macro and Finance (MMF), and UEM Conference 2002 for their helpful comments. We thank also the editors and referees of this journal for their advice and suggestions. An Appendix containing details of algebraic derivations in Section 4 of this paper can be found on the AER web site and on the authors’ site at www.econ.bbk.ac.uk/faculty/driffill 1 He examines a government that delegates monetary policy to an in-dependent central bank, and that faces costs if it interferes in the policy decisions of the bank by appointing a new central banker to obtain a preferred result. He shows that delegation makes it more dif-ficult to sustain the credibility of optimal monetary policy. We show here that this result emerges because Jensen examines a restricted range of policy actions for the government. When this restriction is lifted, the result is reversed. By means of suitable announcements of contracts for the central bank, combined with appropriate actually implemented contracts, delegated policy enables zero inflation to pre-vail in economies in which it could not do so without delegated policy. These economies are ones that have relatively low discount factors.

This paper examines interactions between monetary policy and financial stability. There is a general view that central banks smooth interest rate changes to enhance the stability of financial markets. But might this induce a moral hazard problem, and induce financial institutions to maintain riskier portfolios, the presence of which would further inhibit active monetary policy? Hedging activities of financial institutions, such as the use of interest rate futures and swap markets to reduce risk, should further protect markets against consequences of unforeseen interest rate changes. Thus, smoothing may be both unnecessary and undesirable. The paper shows by a theoretical argument that smoothing interest rates may lead to indeterminacy of the economy's rational expectations equilibrium. Nevertheless, our empirical analysis supports the view that the Federal Reserve smoothes interest rates and reacts to interest rate futures. We add new evidence on the importance for policy of alternative indicators of financial markets stress.