Incentive Schemes for Central Bankers Under Uncertainty: Inflation Targets versus Contracts

Abstract

The implications of uncertain policy preferences for the targeting and contracting approaches to monetary policy are investigated. It is shown that, in the presence of uncertain preferences, a linear incentive contract in the sense of Walsh performs better than an explicit inflation target as proposed by Svensson. The reason is that an inflation target produces a higher variance of inflation. It is also shown that it is optimal to offer a linear inflation contract that does not depend on the degree of preference uncertainty.