Institutional Arrangements for Monetary Policy When Output Is Persistent

Abstract

A discretionary monetary policy gives rise to a constant average inflation bias, a state-contingent inflation bias, and a stabilization bias when output is persistent. The paper considers institutional arrangements (contracts) for central banks that remove these policy imperfections. The average and state-contingent inflation biases can be removed by directing the central bank to target the growth of nominal income and appoint a central banker with a specific relative weight attached to output stabilization. An alternative to this institutional solution is to direct central banks to aim for a feasible output target. Although this would remove the inflationary biases, the government must appoint a liberal (as opposed to conservative) central banker in order to implement optimal stabilization.