Working Paper No. 52
By Matthew B Canzoneri, Charles Nolan and Anthony Yates
This paper re-examines the credibility-flexibility trade-off in monetary policy given recent suggestions that contractual solutions are readily available. Absent the feasibility of a fully state-contingent contract, an aversion on the part of the authorities to the level of the real interest rate, akin to the traditional output distortion, generates an inflation bias which is a function of the supply shock. The state-contingent inflation bias means the optimal contract is no longer a first-best solution. Comparing a second best contract with another regime for achieving monetary stability, a stylized ERM, demonstrates that which is more desirable depends on the nature of the 'political economy' distortions. We discuss which of these two mechanisms may be more practicable in the real world.