Working Paper: CEPR ID: DP1562
Authors: Roel M. W. J. Beetsma; Henrik Jensen
Abstract: 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.
Keywords: monetary delegation; inflation contracts; inflation targets; uncertainty
JEL Codes: E42; E52; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Optimal linear inflation contract (E31) | performs better than optimal inflation target (E31) |
| Optimal linear inflation contract (E31) | stabilizes output and inflation fluctuations (E63) |
| Combination of linear contract and inflation target (E61) | eliminates inflation bias and variability not associated with supply shocks (E31) |
| Quadratic contracts (D86) | mitigate excess macroeconomic variability stemming from central banker uncertainty (E19) |
| Delegation of monetary policy (E52) | may not always improve stabilization outcomes (C62) |