Central Bank Independence in Transition Economies

1.3. Reducing Inflationary Bias — Imperfect Information and 

Reputation 

In subsequent works, originating from the basic model, various ways of reducing 

inflation without binding commitments are considered. Barro and Gordon (1983b) 

introduce a concept of reputation into the analysis, showing that the low inflation 

history can reduce inflationary bias in the economy. They consider a multiperiod 

extension of the model where policymakers announce a rule specifying a constant 

inflation rate and minimise the present value of the loss function. Under some arbitrary 

assumptions about formation of expectations, policymakers decide whether to inflate 

or not by comparing expected gains from breaking the rule with the expected present 

value of the loss from having higher inflationary expectations in the next period. Barro 

and Gordon (1983b) show that the resulting inflation rate is lower than in the 

discretionary equilibrium but higher than in case when binding precommitments are 

possible. 

Backus and Driffill (1985)

2

 extend the Barro and Gordon (1983b) model by 

introducing uncertainty about the policymakers' preferences. In their model there are 

two types of policy maker: a type 1 who cares about price stability only and a type 2 

who is tempted to increase output. The reputation is the subjective probability that the 

policy maker is a type 1

3

. This probability is updated by a Bayesian rule as long as the 

policy maker behave as a type 1. It is profitable for type 2 to behave as type 1 to build 

up reputation and lower inflationary expectations. By breaking the commitment to 

price stability, type 2 reveals his “true nature” and looses reputation. If the 

policymakers' initial reputation is high enough and they optimise over a long horizon, 

there is some initial period in which the expected and actual inflation equals zero 

(which tends to infinity as the optimising horizon tends to infinity). It follows that the 

                                              

2

 Similar model was developed by Barro (1985). 

3

 There is a pooling equilibrium in the model i.e., private agents cannot distinguish immediately 

the policy maker type. Vickers (1986) has developed the model with separating equilibrium i.e., where 

the type 1 successfully reveals its identity. 

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