The Principal – Agent Model

The most significant development in central banking since the Rogoff model has

been the principal – agent / optimal contract models initially developed by Walsh

(1993), Persson and Tabellini (1993). These models attempt to solve the problem

of inflationary bias by structuring a contract between the government (the

principal) and the central bank (the agent) that imposes costs on the central bank

when inflation deviates from the target. The inflation penalty is linear in design

and thus conceptually easy to design with a linear subsidy payment to the bank if

inflation is below the target. The government specifically sets all the targets in the

terms of the contract, therefore the central bank has no goal independence but is

delegated complete instrument independence. New Zealand was heavily

influenced by this development in theory and used it in the design of the 1989

Act, forever transforming the operating nature of the Reserve Bank.