Central Bank Independence in Transition Economies

1.2. Models of Monetary Policy Games 

1.2.1. Basic Model 

Motives for monetary expansion described in the previous section turned out to 

be extremely important in the analysis of a dynamic inconsistency problem by 

Kydland and Prescott (1977). The dynamic inconsistency emerges when the decision 

optimal in the initial period is no longer optimal in the next period, even if no new 

information has appeared. This kind of problem may emerge where the optimal policy 

before private agents' contracts are set is different from the optimal policy afterwards. 

When the policymakers are ready to trade off more employment for higher inflation, 

they have incentive to inflate after the contracts have been set. Kydland and Prescott 

(1977) showed that, if agents expectations are rational, the resulting equilibrium is 

sub-optimal: unemployment is unchanged while inflation is higher. Because the results 

established in this and other policy games models are fundamental in analysis of the 

theoretical foundations of Central Bank independence this section is more detailed and 

begin with a description of the basic monetary policy game model, popularised by 

Barro and Gordon (1983a). The presentation is based on Cukierman (1992). 

The first relation in the model is the “expectation augmented” Phillips curve: 

 

u

t

 = 

λ(π

et

 - 

π

t

) + u* 

 

λ 

> 

0 

     (1), 

 

Where ut is unemployment rate in period t, 

π

t 

is inflation rate, 

π

et

 is expected 

inflation and u* is the natural rate. The relationship may be interpreted as a Lucas 

                                              

1

 The higher rate prompts commercial banks to offer higher interest rates on deposits in order to 

collect more funds and invest in profitable bonds. General interest rate level increases. However, some 

of the banks' funds are already lent and pay lower rate of interest. In result, the banking sector's profits 

are lower. 

---