Credibility of optimal monetary delegation: do we really need prohibitive reappointment costs?

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Description/Abstract

The paper examines the current debate on the real effectiveness of delegation in overcoming the problem of time inconsistency that afflicts discretionary monetary policy. An important contribution by Jensen has shown that, when the government is unable to credibly carry out optimal policy and delegates monetary policy to a central banker with an announced incentive scheme, optimal policy can be credible only if reappointment costs are prohibitive. This finding is questioned in the present analysis. In particular we show that, when delegation is not considered as an alternative, but rather as supplementary, to reputation and is conducive to reputation building for the central banker, the circumstances under which optimal delegation can be credible need not be so extreme. This different result is based on the constraint that the central banker's reputation for low inflation imposes on the government's temptation to deviate from its announcements and on the role played by incentive schemes in strengthening the central banker's reputation.