Central Bank Reputation, Cheap Talk and Transparency as Substitutes for Commitment: Experimental Evidence

Abstract: We implement a repeated version of the Barro-Gordon monetary policy game in the laboratory. Our first aim is to assess whether reputation can serve as a substitute for commitment when central banks are free to operate in a discretionary manner. Specifically we ask whether in a repeated game setting, reputational considerations enable the central bank to implement the forward-looking, efficient Ramsey equilibrium, and avoid the discretionary but time consistent one-shot Nash equilibrium involving higher inflation but no difference in output. We find that reputation is a poor substitute for commitment. We then explore in the repeated discretionary environment whether cheap talk, policy transparency or economic transparency by central bankers can yield improvements in the direction of the Ramsey equilibrium relative to the absence of such mechanisms. Of the three mechanisms we consider, cheap talk fares the best in terms of welfare performance relative to the pure discretionary environment. However, the welfare gains from cheap talk decrease over time. Surprisingly, the real effects of supply shocks are better mitigated by a commitment regime in which monetary policy does not respond to shocks than in any discretionary regime. Thus, there is no trade-off between flexibility and credibility. Ou