Policy Credibility: Why We Trust What the Government Says
1. The Magic of Being Believed: How Credibility Works
Imagine your teacher says, "If you finish your homework, there will be no test tomorrow." If the teacher always keeps such promises, you work hard. But if the teacher often changes their mind, you might ignore the promise. The same logic applies to governments. Policy credibility is about consistency between words and actions.
For example, if a central bank (like the Federal Reserve in the US) promises to keep prices stable, but then prints too much money, people lose trust. They start expecting high prices (inflation) and ask for higher wages, which actually causes inflation. This is called a self-fulfilling prophecy. A credible central bank can stop inflation just by talking, because everyone believes it will act.
| Scenario | What the Government Says | What People Believe | The Result |
|---|---|---|---|
| High Credibility | "We will keep inflation at 2%." | "They mean it. Prices will stay stable." | Businesses set prices low; inflation stays at 2%. |
| Low Credibility | "We will keep inflation at 2%." | "They always change their mind. Prices will rise 5%." | Workers demand 5% raises; inflation jumps to 5%. |
2. Real-Life Examples: When Promises Worked (or Didn't)
🏦 The German Hyperinflation (1923): After World War I, the German government printed money to pay debts, breaking its promise of stable currency. People stopped trusting the money's value. They rushed to spend it immediately, which made prices explode. A basket of bread that cost 1 mark in 1919 cost 200 billion marks by late 1923. This is a classic case of zero credibility.
🇩🇪 The Bundesbank (1980s-1990s): In contrast, Germany's central bank had a strong reputation for fighting inflation. Even when it simply warned about inflation, unions and companies adjusted their behavior. The bank didn't always need to raise interest rates—its credibility did the work.
📉 The Volcker Shock (USA, 1980s): To stop high inflation, Fed Chair Paul Volcker promised to reduce money supply. It was painful (interest rates hit 20%), but he stuck to the plan. After a few years, people believed him. Inflation dropped from 14% to about 3%. His consistency built lasting credibility.
3. Important Questions Students Ask
Sometimes, governments face the "time inconsistency" problem. They want to promise low inflation to calm everyone down, but later they might be tempted to print money to create a temporary boom (like before an election). If they give in to this temptation, they lose credibility for the future.
By being transparent, sticking to rules, and sometimes by giving independence to institutions like a central bank. For example, if a law says the central bank must focus only on price stability, and it's hard for politicians to fire the bank's leader, people trust the bank more.
Yes, indirectly. Economists look at things like "inflation expectations" from surveys or market data (like the difference between regular bonds and inflation-protected bonds). If people expect inflation to be near the government's target, credibility is high.
📝 Footnote
[1] Central Bank Independence: When a country's main bank (like the Fed or ECB) can make decisions without political pressure.
[2] Time Inconsistency: A situation where a decision that seems best today might be bad in the future, making past promises unbelievable.
[3] Inflation Expectations: What people, businesses, and investors think will happen to prices in the future.
[4] Reputation: The collective memory of how a government has kept (or broken) promises in the past.