Reputation building in a monetary policy game

Abstract

This paper examines the notion of reputation building on the part of the central bank as a means of eliminating socially suboptimal inflation rates that arise in monetary policy games. The framework developed here explicitly models the behavior of wage setters, and it is shown that in the Nash equilibrium these private agents do not attain their desired outcome. Hence, wage setters have an incentive for engaging in a reputation-building game with the central bank. In this game, wage setters are allowed to select “optimally” a reputation based wage strategy, thereby making the strategy choice endogenous. This framework thus lays the groundwork for models in which the private sector behaves as a strategic player. It is shown that there exists a wage contract resembling an indexing arrangement which eliminates the suboptimal inflation rate. Finally, a discussion on the ways of restricting the number of permissible solutions to this game is presented.