Academic journal article Journal of Money, Credit & Banking

Inflation Band Targeting and Optimal Inflation Contracts

Academic journal article Journal of Money, Credit & Banking

Inflation Band Targeting and Optimal Inflation Contracts

Article excerpt

WITH THE DEVELOPMENT of the literature on the time-inconsistency problem in Kydland and Prescott (1977), Calvo (1978), and Barro and Gordon (1983), there has been an increasing recognition both by policymakers and the academic literature that solving the time-inconsistency problem is crucial to the successful conduct of monetary policy. The time-inconsistency problem arises because there are incentives for the monetary policymaker to try to exploit the short-run tradeoff between employment and inflation to pursue short-run employment objectives using expansionary monetary policy, although the result is poor long-run outcomes--higher inflation, with no benefit on the output front.

Two approaches have been suggested in the literature to cope with the time-inconsistency problem: appointment of a conservative central banker (Rogoff 1985) or adoption of optimal contracts for monetary policymakers (Walsh 1995). Although both these approaches have attractive theoretical properties, they are difficult to implement in practice. It is likely to be quite difficult to find a central banker with the "right" preferences and it is hard to believe that politicians would naturally want to appoint central bankers with different preferences than theirs. Also, an opportunistic government would also be unlikely to appoint a conservative central banker, so that a regime based on having a conservative central banker is unlikely to be stable over time.

Optimal inflation contracts, usually thought of as pecuniary contracts between the government and the monetary authorities, are also unattractive because central bankers are not paid very highly, and this is particularly true in the United States, where the chairman of the Board of Governors is paid far less than many economics professors. Thus, it is highly unlikely that governments would be willing to write an inflation contract that would give a central banker sufficient incentives to produce optimal policy. Furthermore, public officials are almost never paid on the basis of their performance and we know of no central banker anywhere in the world that has performance-based pay. It also seems politically untenable to write an explicit inflation contract in which the central bank is rewarded for undershooting the optimal inflation rate. (1) Finally, in order for the inflation contract to be optimal it requires that we know how much the central banker values his office and that the monetary costs inflicted on the central baker would have to be translatable into utility units. This feature seems unappealing from a practical standpoint.

This paper argues that inflation band targeting, in which the central bank is assigned a target range and bears some cost if inflation goes outside the range, presents an alternative and more feasible approach to address the time-inconsistency problem. Indeed, inflation band targeting has already been adopted by many central banks. For example, the Reserve Bank of New Zealand is required to keep inflation within the range of 1%-3% and in case of failure the governor is subject to dismissal. The Bank of England has a target range of plus/minus 1% around a 2% inflation target, and if it fails the governor is required to write a public letter to the government explaining why. We show that inflation band targeting regimes belong to a specific subclass of inflation contracts characterized by a particularly simple form, making them easy to adopt. (2) In fact, we are not arguing against the feasibility of inflation contracts in general, but rather the infeasibility of an optimal inflation contract as discussed above.

Inflation band targeting has several advantages relative to either appointment of a conservative central banker or optimal inflation contracts. First, it eliminates the problem of finding the perfect central banker with the right preferences. Second, the framework is likely to be stable over time once the government has agreed to it. …

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