Monetary Policy, Reputation and Hysteresis

Backus and Driffill have shown that reputation has a disciplinary effect on weak monetary policy makers if output shocks are not persistent. In European countries, however, one observes hysteresis in output and employment. The present signaling game examines the effect of hysteresis on the labour market on the results of the repeated monetary policy game. Disciplinary effects of reputation disappear in the presence of hysteresis. Thus, reputation alone is not a sufficient device for establishing monetary discipline. We discuss alternative concepts for central bank credibility which rely on contracts rather than on central bank independence alone