In Discussion Paper No. 1387, Ali al-Nowaihi and Research Fellow Paul Levine provide a critical examination of Walsh's influential proposal (1995) to link the income of central bankers to observed macroeconomic variables, output and inflation. In particular, they argue that the ‘Walsh contract’ does not in itself solve the time-inconsistency problem because the renegotiation option, where all parties benefit, is not addressed. This option, however, destroys the credibility of the contract as a commitment device. On the other hand, it is acknowledged that the great strength of the Walsh contract is that it turns the credibility problem into a publicly highly visible renegotiation problem. By making the conduct of monetary policy open and accountable, the Walsh contract can create an incentive for ‘good’ policy decisions.

If honesty enters ‘good’ government's utility functions, they will never renegotiate and ‘bad’ governments will find it optimal to mimic them. In the resulting pooling equilibrium, Walsh contracts are never renegotiated and the credibility problem is solved. The solution provided in this paper shows that the optimal stabilization rule can be sustained by a Walsh contract until near the end of the government’s term in office. Moreover, this type of contract does not make excessive demands on the observational powers of the private sector.

Independent but Accountable: Walsh Contracts and the Credibility Problem
Ali al-Nowaihi and Paul Levine