Walsh’s Contract and Transparency about Central Bank Preferences for Robust Control

Within a New Keynesian model subject to misspecification, we examine the quadratic contracts in a delegation framework where government and private agents are uncertain about central bank preferences for model robustness. We show that, in the case of complete transparency, the optimal penalty is decreasing in terms of the preference for robustness. In effect, a central bank reacts more aggressively to supply shocks when the model misspecification grows larger. Furthermore, beginning from the equilibrium of perfect transparency and assuming that the average preference for robustness is sufficiently high, the central bank has then an incentive to be less transparent in order to reduce the optimal penalty. Under similar conditions, we also find that greater opacity will increase inflation and output variability.