In a standard New Keynesian model, a myopic central bank concerned with stabilizing inflation and changes in the output gap will implement a policy under discretion that replicates the optimal, timeless perspective, precommitment policy. By stabilizing output gap changes, the central bank imparts inertia into output and inflation that is absent under pure discretion. Even a fully optimizing (i.e., non-myopic) central bank operating in a discretionary policy environment achieves better social outcomes if it focuses on inflation and changes in the output gap than are achieved under inflation targeting.(This abstract was borrowed from another version of this item.)

This paper adopts a principal-agent framework to determine how a central banker's incentives should be structured to induce the socially optimal policy. In contrast to previous findings using ad hoc targeting rules, the inflation bias of discretionary policy is eliminated and an optimal response to shocks is achieved by the optimal incentive contract, even in the presence of private central-bank information. In the one-period model that has formed the basis for much of the literature on discretionary monetary policy, it is shown that the optimal contract ties the rewards of the central banker to realized inflation.

The Federal Reserve has been criticized for allowing the base from which it calculates its target growth paths for the monetary aggregatesto drift from year to year in response to past deviations from target.Drift in the base implies that target misses permanently affect the levels of the monetary aggregates. Using a simple theoretical model, this paper shows that the optimal degree of base drift consistent withprice stability depends on the importance of permanent versus transitory income and velocity disturbances. Neither zero base drift nor complete base drift are likely to be compatible with price stability.