Working Paper: CEPR ID: DP1387
Authors: Ali Ainowaihi; Paul Levine
Abstract: Walsh (1995) addresses the government-central bank principal-agent problem where there exists a severe information extraction problem. This is solved by a ?Walsh contract? which links the income of the central bank to observed macroeconomic variables, output and inflation. The contract does not solve the time-inconsistency problem, however. There will be circumstances where a renegotiation of the contract benefits all parties involved and non-renegotiation-proofness destroys its credibility as a commitment device. But the contract?s strength is that renegotiation can be very visible and this facilitates a reputational solution to the problem, set out in this paper.
Keywords: central bank; contract; credibility; renegotiation; reputation
JEL Codes: C72; E61
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Walsh contracts (J41) | central bank's adherence to socially optimal monetary policy (E52) |
| renegotiation opportunities (L14) | credibility of Walsh contracts (D86) |
| renegotiation (C78) | inflationary bias (E31) |
| visibility of renegotiation (L15) | reputational mechanisms for compliance (D70) |
| incentives for government and central bank (E52) | optimal implementation of Walsh contracts (D86) |