Optimal Contracts for Central Bankers and Inflation and Exchange Rate Targeting Regimes

This paper analyses the implications of adding a foreign exchange rate term to the loss function in the standard model for the issues of discretion and commitment in monetary policy. It is found that neither a linear state-contingent inflation contract for the central bank nor an explicit state-contingent inflation target (that implies a state- contingent foreign exchange rate target) combined with a weight- conservative central bank can now achieve the equilibrium matching that of an optimal rule under commitment. A linear state-contingent contract in a variable that is a weighted average of inflation in excess of target and of the rate of depreciation in the foreign exchange rate in excess of target is now required to mimic the optimal rule under commitment.