Incentive schemes for central bankers under uncertainty: inflation targets versus contracts

Working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 25 November 1998

Working paper No. 88
By Eric Schaling, Marco Hoeberichts and Sylvester Eijffinger

We look at the implications of uncertain monetary policy preferences for the targeting and contracting approach to monetary stability. It turns out that in the presence of uncertain preferences a linear incentive contract in the sense of Walsh (1995) performs better in terms of social welfare than an explicit inflation target as proposed by Svensson (1997). The reason is that, although both approaches can get rid of the inflationary bias, the impact of uncertain preferences on the variance of inflation will be considerably higher with an inflation target. Contrary to Beetsma and Jensen (1998) we find that the optimal inflation target depends on the degree of preference uncertainty. For the case of the Walsh contract, unlike Beetsma and Jensen, we find that it is optimal to offer a linear inflation contract to a central banker that does not depend on the degree of uncertainty about its preferences.

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