The Issue of Instability in a Simple Policy Game Between the Central Bank and a Representative Union

Abstract:     
In the recent economic literature the independence of the central bank is often considered to be one of the most effective guarantees to achieve price stability. A strong theoretical basis of this proposition is that the monetary policy delegation given to an independent central bank is an optimal instrument to avoid the time inconsistency problem of monetary policy. This paper investigates the stability properties of this solution in a simple game in which the private sector (i.e. the trade unions) and the public sector (i.e. the central bank) simultaneously interact. A representative monopoly union is considered, and - in line with the recent economic debate - two types of unions are investigated: i) the standard micro-founded trade union; ii) the inflation-averse trade union. In both cases, we find that the requirement that the Nash equilibrium be stable imposes a limit to the conservativeness of the central bank. Instability of the Nash equilibrium reveals a strategic coordination failure between the public and the private sector.

Number of Pages in PDF File: 20

Keywords: Central bank independence, inflation bias, inflation spiral, stability

JEL Classification: E52, E55, E61, J51, C62, C70

working papers series