Central Bank Institutional Design and the Output Cost of Disinflation: Did the 1989 New Zealand Reserve Bank Act Affect the Inflation-Output Tradeoff?

The 1989 Reserve Bank of New Zealand Act provides a natural experiment in which the effects of institutional change on economic relationships can be studied. The Act set price stability as the single objective of monetary policy and gave the Bank great independence in achieving that goal. We explore the mechanisms through which central bank institutional reforms such as the 1989 Act may affect economic structure, focusing on the output cost of disinflation (short-run inflation-output tradeoff). Three basic channels are identified based on: (i) the inflation environment and menu costs (New Keynsian theory); (ii) misperceptions of shocks, and (iii) wage contracting behavior which is the outcome of time-consistent equilibrium behavior involving strategic interaction between the central bank, firms and unions. Our empirical work investigates changes in the short-run inflation-output tradeoff, allowing environments where learning about the new regime is assumed to be rapid as well as slow. We find that a major shift in the New Zealand tradeoff has occurred since the 1989 Act and that enhanced central bank credibility, in the sense that public expectations of inflation measured by survey data are closer on average to the central bank public projections, lower the output cost of disinflation. Lower average inflation, by contrast, tends to raise the output cost of disinflation.