DP1387 | Independent but Accountable: Walsh Contracts and the Credibility Problem

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Walsh (1995) addresses the government-central bank principal-agent problem where there exists a severe information extraction problem. This is solved by a ?Walsh contract? which links the income of the central bank to observed macroeconomic variables, output and inflation. The contract does not solve the time-inconsistency problem, however. There will be circumstances where a renegotiation of the contract benefits all parties involved and non-renegotiation-proofness destroys its credibility as a commitment device. But the contract?s strength is that renegotiation can be very visible and this facilitates a reputational solution to the problem, set out in this paper.