Designing institutions for monetary stability

Abstract

Lack of credibility or political feasibility are typically cited as serious obstacles to achieving monetary stability. We ask what kind of institutional reforms may help resolve such incentive problems in monetary policy, by help of the new theory of information, contracts and regulatory design. Credibility problems can be resolved by a remarkably simple performance contract that imposes a linear penalty for inflation on the central bank. Results extend when contracts cannot be conditioned on the state of the economy, in which case central bank announcements become important. When only incomplete and simple contracts can be embodied in the central banking institution, a tradeoff between incentives and information emerges; however, optimum institution design may circumvent the tradeoff between credibility and flexibility that has been stressed in the literature.