How Can Inflation Contracts Discipline Central Bankers When Agents Are Learning?

Abstract

This paper studies, in a new Keynesian model with a positive optimal output gap, how to design linear inflation contracts to shape the central bank's incentive structure when private expectations are based on adaptive learning. In this model, under rational expectations, inflation contracts could only partially deal with the time-inconsistency problem arising from incentives for the central bank to exploit the inflation-output trade-off induced by an “overambitious” output-gap target. This is true even if the government incurs no cost related to such contracts, unlike in the Barro–Gordon framework. When agents are learning, their design should reflect the intertemporal trade-off due to learning such that the optimal inflation penalty rate decreases from the high-level set under optimal discretion and rational expectations and then approaches gradually, but does not equal, the low-level set under optimal limited commitment and rational expectations as the learning gain tends to unity.