DP1562 Inflation Targets and Contracts with Uncertain Central Banker Preferences

Author(s): Roel Beetsma, Henrik Jensen
Publication Date: January 1997
Keyword(s): Inflation Contracts, Inflation Targets, Monetary delegration, Uncertainty
JEL(s): E42, E52, E58
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=1562

Within a standard model of monetary delegation we show that the optimal linear inflation contract performs strictly better than the optimal inflation target when there is uncertainty about the central banker?s preferences. The optimal combination of a contract and a target performs best, and eliminates the inflation bias and any variability not associated with supply shocks. Variability due to shocks is enhanced by uncertain central banker preferences however, which suggests the need for alternative incentive mechanisms. Quadratic contracts are shown to partly overcome the problem. Still, the advantages of delegation may be dominated by the ?excess variability? due to shocks.