What is the Central Banks Game?
In this papaer we, first, by explicitly taking account of the private sectors influence and pressure on the monetary authorities, provide a more plausible representation of the motivations of the two main players. We then incorporate persistence into the model and show that the optimal policy of the authorities will be state dependent. Finally and most importantly, we highlight an inconsistency between two strands in the literature of monetary analysis, namely the long lags of monetary policy and the time inconsistency. Such a lag of monetary policy means that the policy will be transparently observed before it affects the economy, consequently the Central Bank cannot fool anybody who has not already bound herself into a contract longer than the lag. Even if such contracts are pervasive, the inflationary bias arising from time inconsistency much be must smaller than previously assessed.
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