Central Banker Contracts, Incomplete Information, and Monetary Policy Surprises: In Search of a Selfish Central Banker?

Approaching monetary policy as a principal-agent problemprovides a useful framework for interpreting alternativedelegation schemes. In this paper, we consider theeffectiveness of central banker incentive schemes when theprincipal delegates monetary policy through contracts butremains uncertain about the central banker's responsiveness tosuch schemes. We adopt a simple principal-agent model andassume that the central banker's trade-off between socialwelfare and the incentive scheme is private information. Weconsider two types of central bankers; one who responds to theincentive scheme (``selfish'') and one who does not and onlycares about social welfare (``benevolent''). We demonstratethat when a benevolent central banker accepts a contractdesigned for a selfish central banker, positive inflationsurprises occur and output exceeds its natural rate. Wefurther show that a benevolent central banker with aninflation bias has an incentive to masquerade as selfish.Mechanisms exist that solve that problem by achievingpreference revelation. We consider a simple mechanism indominant strategies that induces the benevolent type eithernot to breach or not to accept the appointment (contract) inthe first place. This multi-period mechanism works with eitherinflation targets, or the appointment of a conservativecentral banker. Our results suggest that more complicatedincentive schemes, embedded within broader constitutionalarrangements, are required in the presence of privateinformation for them to work effectively.