Knowledge that Transforms

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.