DP1562 | Inflation Targets and Contracts with Uncertain Central Banker Preferences

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Within a standard model of monetary delegation we show that the optimal linear inflation contract performs strictly better than the optimal inflation target when there is uncertainty about the central banker?s preferences. The optimal combination of a contract and a target performs best, and eliminates the inflation bias and any variability not associated with supply shocks. Variability due to shocks is enhanced by uncertain central banker preferences however, which suggests the need for alternative incentive mechanisms. Quadratic contracts are shown to partly overcome the problem. Still, the advantages of delegation may be dominated by the ?excess variability? due to shocks.