Monetary policy when the objectives of central bankers are imperfectly observable

Abstract

AbstractThe paper presents a theoretical model for analysis of the imperfect observability of central bank preferences by the private sector on the decisions taken by the monetary authority, and therefore, on the inflation rate. It examines, in particular, the connection which, in the presence of a time‐inconsistency problem, arises between the observability of the monetary institution's goals and its equilibrium strategies. The model yields innovative results from the technical and economic points of view. From the technical point of view, it is possible to identify the conditions on the model's parameters under which a pure separating equilibrium arises, and the conditions under that there instead exists a “hybrid” equilibrium in which some types of Central Bankers adopt separating strategies whilst others adopt pooling strategies. From an economic point of view, the paper shows a number of relations that arise, in equilibrium, between the degree of observability and transparency of the Central Banker's goals and the inflation rate set by the Central Banker.