Bayes correlated equilibrium and inflationary bias
Building on these insights, we advocate the use of Bayes Correlated Equilibrium (BCE), devised by Bergemann & Morris 2013, as a tool in monetary policy to address inflationary biases resulting from time inconsistency. The rationale behind this proposition is centred in the growing need for policies that not only respond to immediate economic disruptions, but also pre-empt future inflationary bias. The nonlinear Phillips curve model proposed by Harding et al. 2023 emphasizes the significance of these policies, particularly when inflationary pressures are high, suggesting that the traditional linearized models may not capture the full spectrum of inflation dynamics post-crisis. Our overall aim is to prove that by adopting a BCE framework, a predictive mechanism for central banks to model (and hence forecast) interactions between policy moves (from policy makers) and market behaviour (from market participants) is offered, providin g a ‘correlated’ path towards more stable and time-consistent policy outcomes that can maintain inflation within the target rate. Despite the extensive body of literature on monetary policy and its implications for inflation, no existing studies explicitly apply BCE within the context of central bank (CB) policymaking to limit inflationary biases. This observation establishes the uniqueness of the approach proposed in this paper, aiming to bridge theoretical economic models with practical policymaking tools.
Literature review
The relevance of time-inconsistency in monetary policy has been analysed in detail in economic literature and has led to positive theories of inflation owed primarily to an inflationary bias that might arise when authorities conduct monetary policy with discretion. This and the impact of rules vs. discretion employing the idea of time-consistency was first presented by (Kydland & Prescott 1977). The importance of this issue is self-evident. From it, you can deduct the incentives that the CB faces when it conducts its monetary policy, and therefore, they design institutions that best serve the well- functioning of the economy. The design of these institutions implicitly assumes that monetary policy is able to affect, at least in the short-run, real variables of the economy and act up to the role the CB was assigned, i.e. stabilization. The remainder of this section does not seek to question this assumption, but to understand how this inflationary bias comes about.
Framework for the application of game theory in monetary policy
i) Information asymmetry in monetary decisions – our model provides an asymmetric information distribution favouring the CB, enabling it to respond effectively to economic shocks, i.e. the argument of monetary stabilization policy (Woodford, 2003). ii) Rational expectations within information limits – agents’ expectations are modelled as rational yet constrained by limited information. This disparity in data accessibility modulates agents’ behavioural responses to the CB policy shifts. iii) Strategic monetary tools deployment – the CB employs a range of monetary policy tools including interest rates and QE aimed at macroeconomic stabilization, demonstrating an active engagement with forward-looking monetary regimes. iv) Adaptive response mechanisms to economic perturbations – the CB adapts its approach based on current economic conditions, allowing for both immediate and delayed responses to economic shocks.
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