The Effect of Policy-Maker Reputation and Credibility on Public Expectations

Abstract

We sometimes observe situations in which governments - policy-makers - change policy and agents do not respond. One reason for the lack of response is the policy-maker's reputation and its effect on the credibility of the new policy. If a new policy is enacted in the face of a reputation that is exactly the opposite of the policy's intended effect or consequence, then the policy's low credibility leads to public skepticism about the new objective or threat. Agents will not alter their behavior since they believe the policy is temporary. This theory is tested by examining two recent changes in US macroeconomic policy that had implications for inflation expectations. The more general point, however, is that reputation and credibility hinder or enhance a policy-maker's effectiveness. In this particular example the public's nonresponse has the additional consequence of `prolonging the agony' of austerity policies designed to reduce inflation expectations or it can give policymakers `running room' to stimulate the economy, without a subsequent increase in inflation expectations.