Jingyuan Li
Department of Economics
Texas A&M University
College Station, Texas 77843
Guoqiang Tian
Department of Economics
Texas A&M University
College Station, Texas 77843
Abstract
This paper studies the time inconsistency problem on monetary policy for central banks using a unified approach that combines reputation forces and contracts. We first characterize the conditions for reputation forces to eliminate the inflation bias of discretionary policy. We then propose an optimal contract that can be used with reputation forces to implement a desired socially optimal monetary policy rule when the reputation forces alone are not large enough to discourage a central banker to use a surprise inflation policy. In contrast to most of the existing contracts that are contingent on realized inflation rates which are in turn contingent on production shocks, like the standard reputation model, a central banker in our hybrid mechanism is punished only when she uses a surprise inflation rate. Since the penalty proposed is the lowest one that discourages the central bank from attempting to cheat and
the sum of the loss, reputation forces, and the penalty for the central bank to cheat is the same as the loss at the socially optimal inflation rate, our hybrid mechanism is the most efficient and robust mechanism that implement the socially optimal monetary policy rule.
We also provide a upper bound of the penalty that is be lower than that of the existing contracts when realized inflation rate is greater than a certain level.
Keywords: Monetary policy, time-consistency problem, reputation, optimal contract design, a unified approach
Journal of Economic Literature Classification Number: E52, E58.
