Abstract

Approaching monetary policy as a principal agent problem provides a useful framework for interpreting alternative delegation schemes. In this paper, we consider the effectiveness of central banker incentive schemes when the principal delegates monetary policy through contracts but remains uncertain about the central banker's responsiveness to such schemes. We adopt a simple principal-agent model and assume that the central banker's trade-off between social welfare and the incentive scheme is private information. We consider two types of central bankers; one who responds to the incentive scheme ("selfish") and one who does not and only cares about social welfare ("benevolent"). We demonstrate that when a benevolent central banker accepts a contract designed for a selfish central banker, positive inflation surprises occur and output exceeds its natural rate. We further show that a benevolent central banker with an inflation bias has an incentive to masquerade as selfish. Mechanisms exist that solve that problem by achieving preference revelation. We consider a simple mechanism in dominant strategies that induces the benevolent type either not to breach or not to accept the appointment (contract) in the first place. This multi-period mechanism works with either inflation targets, or the appointment of a conservative central banker. Our results suggest that more complicated incentive schemes, embedded within broader constitutional arrangements, are required in the presence of private information for them to work effectively.

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