Reputation and Optimal Contract for Central Bankers

We implement optimal economic outcomes at the lowest social cost by combining reputation and contracting mechanisms to overcome the time-inconsistency problem of monetary policy associated with an inflation bias. We characterize the condition under which the reputation force alone induces a central bank to behave in a socially optimal way. When this condition fails, an incentive contract is invoked, whose cost is significantly reduced by the presence of the reputation force. The contract poses a penalty threat that is a concave function of wage growth, which in equilibrium is tied to expected rather than realized inflation, with a global maximum that provides the least upper bound on all threatened penalties. This bound can be used as a uniform penalty threat to achieve optimal economic outcomes and still, for moderate to large shocks, its magnitude can be much smaller than the size of the transfers required by the standard contracts that are linear functions of realized inflation rates. Further, under both the concave and the uniform penalty threats, the central bank will behave in the socially optimal way and no transfer is materialized in equilibrium. Thus our hybrid mechanism solves the time-inconsistency problem while leaves the central bank with complete discretion to respond to new circumstances, without any reputation cost or penalty threatened by the contract actually invoked along the equilibrium path.