What should be the principal objective of central bankers? The prevailing view – reflected in the mandates given to the Bank of England and the European Central Bank – is that monetary policy should focus primarily on the maintenance of a low and stable rate of inflation. Indeed, this argument goes, the head of the central bank should be a ''conservative'' – an individual who is more averse to inflation than society in general.
But according to Philip Lawler, writing in the latest issue of the Economic Journal, in economies with unionised labour markets, this conventional wisdom should be turned on its head. In fact, the appropriate central banker is someone who is less concerned about inflation than society as a whole. What''s more, if unions themselves are averse to inflation and take some account of the impact of their wage claims on the inflation rate, then central bankers should be concerned more with employment than they are with inflation.
The explanation for these results lies in the relationship between the conduct of monetary policy, union wage bargaining and the level of employment. What happens is that the stronger the central bank's counter-inflationary stance, the less concerned unions need to be about the inflationary consequences of their wage claims. They know that a conservative central banker will not allow their excessive wage claims to be translated into inflation. In particular, a conservative central bank will allow unions to achieve high real wages at a small inflationary cost. Given the negative relationship between the average real wage and the demand for labour, the consequence of a
conservative central banker is a level of employment lower than is socially desirable.
In contrast, if the central bank''s principal concern is employment, as opposed to inflation, it will prevent high nominal wages being translated into high real wages by implementing an inflationary monetary policy. Knowing that any real wage gains can only be achieved at a high inflationary cost, unions will thus be induced to moderate their wage claims. The outcome is a situation characterised by lower real wages, higher employment and, surprisingly perhaps, a lower inflation rate than that under a conservative central banker.
Although the ultimate logic of this argument is that a central bank that is completely indifferent to inflation provides the welfare-maximising solution from society''s viewpoint, the presence of supply-side shocks moderates this conclusion. Such shocks would, in the absence of any concern by the central bank over inflationary outcomes, lead to an excessive degree of price level variability. Hence, the central bank should attach at least some weight to the inflationary consequences of its monetary policy decisions.
Lawler''s research indicates the relevance of labour market structure to the issue of central bank design. Moreover, in the European context, it suggests the potential drawbacks of implementing a single monetary policy for countries with highly diverse labour markets.
''Centralised Wage Setting, Inflation Contracts and the Optimal Choice of Central Banker'' by Phillip Lawler is published in the April 2000 issue of the Economic Journal. Dr Lawler is at the University of Wales, Swansea.