For instance, in a slump consumers and firms anticipate additional accommodation in the future, thus frontloading consumption and investment. Vice versa, in an overheating phase, consumers and firms restrain current spending to prepare for a more constrained monetary policy environment in the future. In both cases, the reliable anticipation of the future central bank response mitigates the fluctuations.
In other words, central bank credibility acts as an automatic stabiliser by inducing inter-temporal substitution in economic activity. All that’s needed is a clear and credible commitment by the central bank to a certain course of action. But how can we establish such commitment?