DP1387 Independent but Accountable: Walsh Contracts and the Credibility Problem

Author(s): A Al-Nowaihi, Paul L Levine
Publication Date: April 1996
Keyword(s): Central Bank Contract, Credibility, Renegotiation, Reputation
JEL(s): C72, E61
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=1387

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.