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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Paper provided by University of Connecticut, Department of Economics in its series Working papers with number
2002-29.
Length: 36 pages Date of creation: Jan 2002 Date of revision: Publication status: Published in Public Choice, September 2003. Handle: RePEc:uct:uconnp:2002-29
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Find related papers by JEL classification: E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
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References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
Grossman, Gene M & Helpman, Elhanan, 1994.
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American Economic Review,
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Gene M. Grossman & Elhanan Helpman, 1992.
"Protection For Sale,"
NBER Working Papers
4149, National Bureau of Economic Research, Inc.
[Downloadable!] (restricted)
Backus, David & Driffill, John, 1985.
"Inflation and Reputation,"
American Economic Review,
American Economic Association, vol. 75(3), pages 530-38, June.
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