Credibility and the value of information transmission in a model of monetary policy and inflation

In this paper we solve for the optimal (Stackelberg) policy in a model of credibility and monetary policy developed by Cukierman and Meltzer (1986). Unlike the (Nash) solution provided by Cukierman and Meltzer, the dynamic optimization problem facing the monetary authority in this case is not of a linear quadratic form and certainty equivalence does not apply. The learning behavior of the private sector (regarding the policymaker's preferences) becomes intimately linked with the choice of the optimal policy and cannot be separated as in the certainty-equivalent case. Once the dual effect of the optimal Stackelberg policy is recognized, the monetary authority has an additional channel of influence to consider beyond that taken into account by suboptimal certainty-equivalent Nash policy rules. Unlike Nash behavior the Stackelberg solution implies no inflationary bias, while being still (weakly) time-consistent. This makes the Stackelberg solution credible with only stagewise precommitment of the policymaker. In the absence of such a precommitment, learning behavior of the private sector does not sufficiently inhibit the incentive of the monetary authority to cheat in this model despite the fact that this learning is explicitly recognized in the Stackelberg solution.