Central bank's credibility

If people are doubt about the bank’s repayment ability, such bank will most likely not a central bank. Besides, to reduce money supply central bank can sell bond, increase the RRR or increase the discount rate. Thus, we rarely focus on the repayment ability when we are discussing how central bank’s credibility affect the effectiveness of it’s anti- inflation policy.

Actually, the effectiveness of an anti-inflation policy depends on the credibility of central bank. In economic view, we have 2 prices, the actual price and expected price. If credible central bank has declared that she is going to reduce the money supply to flight inflation, firms will reduce their expected price level. And thus, they will raise their product’s price at a lower rate, vice versa. The effectiveness of an anti-inflation policy is depended on how the firms perceive the change of price in the future.

ps. Credible central bank means she will actually act as what has she declared. Trustworthy declaration, firm will alter their expected price level.

One of the ways that central bank to curb inflation is to sell government bonds e.g. US Treasuries to drain the money supply from the over expanding economy. This is called OPEN MARKET OPERATIONS. Howevr, if the central bank's credibility is low, then the investors will not be willing to buy the government bonds as they might afraid the debt-repaying ability of the central bank, then the effectiveness would be low. On the contrary, if the central bank's credibility is high and every people rush to buy their debts, the anti-inflationary policy could be effectively done.