Bayesian Nash equilibria and monetary policy
inflation expectations rise doesn’t really matter’ , the reason why can reduce the frequency of inflation expectations traps.
Modelling the ‘ Transparency Game ’
Transparency’s relevance
Although somewhat irrational, inflation expectations are largely formed by the central bank. Emphasis has recently been placed on the central bank’s communication policy, with the Fed implementing inflation expectations into their monetary policy framework in 2020 (Fed, 2020) and the IMF (Albrizio et al., 2023) recently stating that: ‘ Central banks can encourage expectations to be more forward-looking through improvements in the independence, transparency, and credibility of monetary policy and by communicating more clearly and effectively. ’ The relationship between inflation expectations and the transparency of a central bank on its current and future policy positions is double-edged. The likes of Lisi (2020), Faust & Svensson (2001) and de Haan & Waller (2004) all agree that increasing transparency leads to lower inflation expectations and inflation. Dale, Orphanides, and Österholm (2011) and Morris, Shin & Tong (2006) show that there is a point where being to o transparent infringes on a central bank’s discretionary rights and becomes sub - optimal, where inflation and expectations rise. When creating the game-theoretic model (also known as a ‘ game ’, a situation where players make strategic decisions that consider other players’ actions and responses), this relationship will be characterized by a quadratic payoff function.
Game setup
The game consists of two players:
1. The Central Bank (CB): the CB aims to stabilize inflation and anchor expectations close to a target level or the current rate of inflation (to minimize expectations traps). 2. Market Participants (MPs): this player represents consumers and businesses that form expectations about future inflation based on information from the CB. Their external actions in the economy, such as demanding higher wages, can force the CB into an expectations trap. The information structure is as follows: the CB has private information about its level of transparency, on an increasing scale of 0 to 1, which the MPs do not know but have prior beliefs about. The transparency determines the clarity and complexity of the disclosed information about current economic indicators (e.g. the inflation rate) and policy responses. The game starts at the beginning of an economic period where the CB decides on its transparency level. The moves for the CB are as follows: • Set transparency: they can continuously choose their transparency level on a scale of 0 to 1 (normalized from the 0-15 Eijffinger-Geraats index).
The reactive moves for the MPs are as follows:
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