Central Bank Independence in Transition Economies

1.4.4. Reducing Inflationary Bias — Optimal Contracts 

Walsh (1995) proposed another solution to the time-inconsistency problem by 

adopting a principal-agent framework. He shows that an appropriate contract between 

policymakers and the Central Bank may provide an optimal policy in terms of inflation 

performance and stabilisation of the shocks. The model is based on the standard 

monetary policy game framework. The Phillips curve describes a relationship between 

deviations of output from its equilibrium level, unexpected inflation and aggregate 

supply shocks. The value of the supply shock is assumed to be a private information of 

the Central Banker. The Central Banker and the society share the same preferences 

described by the standard loss function. However, the utility of the Banker depends 

negatively on the value of the loss function and positively on the transfer he receives if 

the performance criteria set for him by the Government are satisfied. The game begins 

from designing the contract for the Central Bank. It is set in terms of a desired money 

growth, so the Bank has no informational advantage over the Government. The exact 

criteria are set by equating money growth computed by maximising the expected 

utility of the Bank with the rate of growth which is optimal response to the supply 

shocks. In the next stage people form expectations. Then the supply shock occurs. 

Finally, the Bank chooses the rate of money growth which, by construction of the 

contract, is optimal for the society. The trade off between credibility and flexibility 

disappears and the inflation is optimal to offset the supply shocks. However, 

McCallum (1995) argues that the Walsh solution does not solve the problem of time-

inconsistency but merely reallocates it. The point is that the Government has exactly 

the same preferences as the Bank and the reinforcement of the contract is questionable.