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.

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.

Persistent unemployment, like that plaguing Europe since the early 1980's, has been a persistent problem for economic theory. Competitive equilibrium theory assumes that all markets clear, including the labor market. All theories of unemployment thus must reflect significant departures from that paradigm. The last 20 years have generated a plethora of such theories. The challenge is to construct models that generate unemployment and are broadly consistent with a host of other labor and macroeconomic phenomena, including patterns of real wages and hours. The traditional approach is to focus on a simple static equilibrium in which wages are kept above their market-clearing level for a variety of reasons: in the older versions of this story minimum wages, union power and normative traditions; in its more recent incarnations, efficiency-wage considerations. Within the United States, the older variants of these models have received decreasing credence, as union power has eroded, the real value of the minimum wage has declined and empirical evidence has buttressed a broader set of theoretical arguments based on imperfect competition within the labor market and efficiency-wage considerations suggesting at most negligible effects from these government interventions.