Bayesian Nash equilibria and monetary policy
Nikhil Shirgaokar
Introduction
Monetary policy
Currently, economies worldwide are grappling with inflationary pressures, influenced by factors such as supply chain disruptions, fluctuating energy prices, and post-pandemic recovery dynamics. These challenges are prompting central banks to reassess and adjust their monetary policies to stabilize prices while fostering economic growth. Monetary policy, a critical tool for managing inflation, involves adjusting interest rates and controlling the money supply. Central banks aim to curb excessive inflation while preventing deflation, ensuring a balance that supports economic stability and growth. By monitoring inflation trends, central banks make strategic decisions to either tighten or ease monetary conditions, influencing borrowing costs, consumer spending, and investment, all of which pivotal in shaping the economic landscape. However, the delivery of monetary policy and the qualities of the central bank can have a deep underlying sway over inflation.
Credibility
Credibility in the context of central banking is a measure of the confidence that economic agents have in the central bank's ability to manage inflation and maintain price stability effectively. Alternatively, it refers to the speed at which the public recognises changes in the objectives of the policymaker (Cukierman and Meltzer, 1986). A central bank is credible if its actions consistently align with its stated policy objectives, thereby influencing economic agents' expectations and behaviours in a manner that supports the bank's policy goals. Credibility is crucial as it enhances the effectiveness of monetary policy; when the public trusts the central bank's commitment to low inflation, they adjust their wage demands and price-setting behaviours accordingly, which in turn helps anchor inflation expectations and achieve price stability at a lower cost. In Cukierman and Meltzer’s proposed model, credibility is higher when monetary control is more transparent and when policymaker s’ objectives are more stable. The strategic use of ambiguity and imperfect credibility can help policymakers to get their way. Credibility is largely the combination of three concepts: independence, transparency, and commitment.
Independence
Discretionary monetary policy refers to the freedom of central banks to manage the economy by making decisions that are not restricted by governmental authority. This quality allows banks to respond to market shocks with fast and effective monetary policy. However, when coupled with ambiguity and asymmetric information with the public, it can spike inflation (Cukierman and Meltzer, 1986). Meltzer and Cukierman’s paper explores how monetary policymakers have politically motivated objective functions (their aims), which have a positive relationship to economic stimulation through policy
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