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AN AGENCY SIGNALING MODEL OF CENTRAL BANK INDEPENDENCE

In the wake of recent financial and economic turbulence, the timeis perhaps ripe for a re-examination of the fundamental theories of centralbank independence. In this project, we revisit two important aspects of thetheory of inflation: (i) the institution of independent central bank and howit is affected by prevailing political climate and public opinion; and (ii)how the central bank manages public expectations through its limited policyinstruments, in order to fulfill a dual mandate of stabilizing prices whilesustaining output and employment. A two-stage model is formulated. In theappointment stage, the type of central banker is strategically chosen by a"government" representing politico-economic interests that may differ fromthe central banker's. Once appointed, the central banker acts with completeindependence in a two-period signaling game against a public withheterogeneous information. In most of the previous literature these twoaspects of the monetary economics have only been analyzed each in isolation.Moreover, the use of signaling games to understand inflation expectationshas been limited to cases with finitely many types, extreme informationaldistributions, or restrictions on parameters that guarantee separatingequilibrium. When these ad hoc modelling assumptions are removed, severalnew and important qualitative phenomena emerge.To begin with, a strategic bias towards anti-inflationary policy isreaffirmed (to the extent that a wide range of governments and centralbankers may pool on a zero-inflation policy). However they hinge on severalfondamental variables related to the degree of transparency, public opinion(off equilibrium beliefs and the degree of public uncertainty about thegovernment. At the same time, we show that monetary policies are oftendoomed to a kind of instability that has- to the best of our knowledge- beenneglected so far. In the equilibrium of this model, depending an the amountof public information among the agents, both the government'sappointment strategy and the central bank's monetary policy can exhibitdiscontinuities. Thus an infinitesimal change in the economic or politicalfundamental can lead to an abrupt change in the central banker's type, or alarge jump in the inflation rate. This phenomenon is all the more strikingsince the discontinuities are not caused by public panic (which, as we knowfrom models of bank runs, can be self-fulfilling). Indeed we have adopted anovel equilibrium selection criterion in the signaling game; namely, thepublic is assumed to be highly sophisticated and calm- it would seek preciseexplanations even for events that are not supposed to occur in equilibrium.We feel this assumption is fitting in the contemporary world, and it provesto have strong implications. In the presence of an uninformed public notprone to panic, the committment of monetary policy to control inflationexpectations and the induced monetary policies are doomed to bediscontinuous in some fundamental parameter measuring the temptation toinflate, when the problem of asymmetric information is sufficiently severe.