Bayesian Nash equilibria and monetary policy
surprises and a negative relationship with monetary growth in the long term (rising inflation). Their preferences and trade-offs (known to them but not the public; this creates asymmetric information) stochastically (unpredictably) shift over time. The resultant information gap means the public cannot accurately predict the central bank’s actions, leading to inflation expectations traps, where misaligned expectations become self-fulfilling. Thus, it is vital the central bank manage the inflation expectations they inadvertently create.
Transparency
A central bank’s communication strategy directly shapes the public’s perception of inflation. The concept of ‘ transparency ’ in central banking is a component of credibility (Cukierman and Meltzer, 1986), controlling how fast the public can react and correlate their inflation expectations with the policies of the central bank. Lisi (2020) hypothesizes that an increase in a central bank’s transparency leads to a decline of inflation. Lisi’s model suggests that inflation is influenced by the public’s ability to anticipate the policymakers’ decisions. The study uses empirical analysis data from ninety -five countries from 1998 to 2010, adopting the Eijffinger-Geraats (2002) index of transparency. The findings indicated that inflation was approximately one-fifth lower in years where central banks adopted greater transparency policies. Similarly, the modified Barro-Gordon model of Faust and Svensson (2001) shows that a higher degree of transparency reduces inflationary bias (de Haan and Waller, 2004). Other studies suggest otherwise, where excessive transparency can result in additional noise around policymakers’ objectives (Dale et al ., 2011) or can induce economic agents to attach too much weight onto a central bank’s announcements (Morris and Shin, 2002) (Morris et al., 2006). Thus, striking a middle ground is vital in determining the optimal level of transparency for central banks to manage inflation effectively. If transparency is too high, the bank can lose control over expectations. If it is low, the public is left to their own self-fulfilling beliefs.
Game theory
Game theory is a mathematical formulation of situations where, for two or more agents, the outcome of an action by one of them depends not only on the particular action taken by that agent but on the actions taken by the other (or others) (Samadi et al, 2018). Following Neumann and Morgenstern's pioneering text, John Nash significantly advanced the theory. Since the 1970s, game theory's applications have expanded across various fields including economics, politics, and biology, demonstrating its growing relevance and utility.
The Prisoner’s Dilemma
Most famously, the prisoner's dilemma illustrates a fundamental concept in game theory, capturing the conflict between individual rationality and collective benefit. In this scenario, two prisoners face a choice: cooperate with each other by staying silent or defect by betraying the other. The dilemma unfolds with their inability to communicate; if both prisoners cooperate, they receive minor penalties (one year each). However, if one defects while the other cooperates, the defector is rewarded, typically
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