Dealing with time-inconsistency: Inflation targeting vs. exchange rate targeting

Abandoning an objective function with multiple targets and adopting single mandate can
be an effective way for a central bank to overcome the classic time-inconsistency
problem. We show that the choice of a particular single mandate depends on an
economy’s level of trade openness and the credibility of the central bank. We begin with
reduced form empirical results which show that as central banks become less credible
they are more likely to adopt a pegged exchange rate, and crucially, the tendency to peg
depends on trade openness. Then in a model where the central bank displays “loose
commitment” we show that as central bank credibility falls, they are more likely to adopt
either an inflation target or a pegged exchange rate. A relatively closed economy would
adopt an inflation target to overcome the time-inconsistency problem, but a highly open
economy would prefer an exchange rate peg.